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Financial Derivatives : An International Perspective

1. Introduction

Over the past two decades, the financial markets have experienced an impressive expansion in terms of securities issued and traded on the secondary markets. In addition, financial markets have become more and more interconnected allowing almost continuous trading in some precious metals, currencies and stocks traded on several exchanges. The securitization process of traditional banking activities - such as the mortgage backed securities appearance - determined one way to expand the risk sharing possibilities of market participants. Financial innovation that led to the issuance and trading of derivative products has been another perhaps even more important boost to the changes and development of financial markets.

Derivative products such as options, futures or swap contracts have become a standard risk management tool that enables risk sharing and thus facilitates the efficient allocation of capital to productive investment opportunities. Moreover, derivative instruments are not redundant securities once the existence of informational asymmetry and market friction is recognized. They thus contribute to complete the financial markets and to gather information that is not readily available from trading in the physical markets.

Financial Derivatives : An International Perspective

The word derivative has only been in common usage for about the last few years or so. Many practitioners in this markets will remember the terms, off-balance sheet instruments, financial products, risk management instruments, and financial engineering- all meaning much the same thing, and now all covered by the expression derivative. Derivatives is simply a new name for a tried and trusted set of risk management instruments. Unfortunately some market participants, not only the banks who provide a service in these instruments, but also some end users, have used these derivative products to speculate widely.

Derivatives have been likened to aspirin : taken as prescribed for a headache, they will make the pain go away. If you take the whole bottle at once, you may kill yourself. The expression derivative covers any transaction where there is no movement of principal, and where the price performance of derivative is driven by an underlying commodity.

A derivative instrument is one whose performance is based (or derived), on the behaviour of the price of an underlying asset, (often simply known as the underlying). The

Financial Derivatives : An International Perspective

underlying itself does not need to be bought or sold. A premium may be due.

Derivatives, as the basic definition of the world implies, are a synthetic by-product created or derived from the value of the underlying asset, be it a real asset, such as gold wheat or oil, or a financial asset, such as a stock, stock index, bond or foreign currency. All derivatives have three essential characterstics: the type of contract, the type of asset underlying the security and the market in which transactions occur exchange traded or over-the -counter (OTC) Common derivative securities include. forward and futures contracts which are agreements between two parities to exchange a specified quantity of an asset at a predetermined price on a future specified date. Option contracts which confer the right. but not the obligation to buy in the case of a call or sell in the case of a put a specified quantity of an asset at a predetermined price on or before a specified future date option contract would expire if it is not in the best interest of the option owner to exercise. Swaps generally trade in the OTC market but there is monitoring of this market segment, which is now the largest segment of the derivatives market, as provided by the International Swap Dealers

Financial Derivatives : An International Perspective

Association (ISDA) and the Bank for international Settlements (BIS) Swaps which are agreement between two parties to exchange cash flows in the future according to a prearrangedformula. In case of popular interest rate swap, one party agrees to pay a series of fixed cash flows in exchange for a sequence of variable cost .

EVOLUTION OF RISK MANAGEMENT TECHNIQUES

Financial derivatives are not new: they have been around for years. A description of the first know options contract can be found in Aristotle a writings. He tells the story of Thales, a poor philosopher from miletus who developed a financial device which thales saying that his lack of wealth was proof that philosophy was useless occupation and of no practical value. But Thales knew what he was doing and made plans to prove to others his wisdom and intellect. Thales had great skill in forecasting and predicted that the olilviie harvest would be exceptionally good the next autumn . Confindent in his prediction, he made agreements with area olives press owners to deposit what little money he had with them to guarantee his exclusive use of their olive presses when the harvest was ready, Thales successfully negotiated low prices because the harvest was in the future and no one

Financial Derivatives : An International Perspective

know whether the harvest would be plentiful or pathetic and because the olive-press owners ware willing to hedge against the possibility of a poor yield. Aristotle ls story about Tahles ends as one might guess: When the harvest time came and many presses were wanted all at once and of a sudden he let them out at any rate which he pleased, and made a quantity of money , Thus he showed the world that philosophers can sort. (3) So Thales exercised the first know options contracts some 2,5000 years ago, He was not obliged to exercise the options . If the olive harvest had not been good, Thales could have let the option contracts expire unused and limited his loss to the original price paid for the options. But as it turned out, bumper crop came in, so Thales exercised the options and sold his claims on this olive presses at a high profit. Options are just one type of derivative instrument , Derivatives is their name implies, are contracts that are based on or derived from some underlying asset, reference rate, or index Most common financial

derivatives, described later, can be classified as one or a combination, of four types swaps, forwards futures, and options that are based on interest rates or currencies. Most financial derivatives traded today are the plain vanilla varietythe simplest form of a financial instrument . But variants on the basic structures have given way to more sophisticated and complex financial

Financial Derivatives : An International Perspective

derivatives that are much more difficult to measure manage and understand for those instruments, the measurement and control of risks can be far more complicated creating the increased possibility of unforeseen losses Wall Street s rocket scientists are continually creating new complex, sophisticated financial derivative products.. However those products are all built on the foundation of the four basic types of derivatives, Most of the newest innovations are designed to hedge complex risks in an effort to reduce future uncertainties and manage risks more effectively, But the newest innovations require a firm understanding of the trade off of risks and rewards . To what and derivatives users should establish a guiding set of principles to provide a framework for effectively managing and controlling financial derivative activities. Those principles should focus on the role of senior management, valuation and market risk management , credit risk measurement and management, enforceability operating systems and controls, and accounting and disclosure of risk management positions.

Development of Financial Derivatives 1972 1973. 1973 Foreign Currency Futures Equity Futures : Futures on Mortgage-backed Bonds Equity Futures

Financial Derivatives : An International Perspective

1975 1977 1979 1980 1981

T-bill Futures on Mortage backed Bonds T-bond Futures Over-the-Counter Currency Options Currency Swaps Equity Index Futures: Options on T bond Futures Bank CD Futures,T- note futures Eurodollar Futures: Interest-rate Swaps

1983

Interest-rate Caps and Floor: Options on: T note, futures: Currency Futures: Equity Index Futures

1985

Eurodollar Options: Swaptions: Futures on US Dollar & Municipal Bond Indices

1987

Average options Commodity Swaps Bond Futures and Options Compound Options.

1989

Three-month Euro- Dm Futures Captions ECU Interest- rate futures Futures on interest rate Swaps.

1990 1991 1992

Equity Index Swaps Portfolio Swaps Differential Swaps

Sources: Phillips, K. Arrogant Capital (Boston: Mass. 1994)

Derivatives have increased in popularity because they offer four distinct characteristics which are not readily found in any one asset or a combination of assets.

Financial Derivatives : An International Perspective

The most important is the close relationship between the value of the derivative and its underlying assets which can be readily used to speculate or hedge. In a speculative transaction the investor can lever his investment through the purchase of the derivative asset which sells for a fraction of the underlying asset, but exhibits almost identical profit potential in absolute dollar value with greater percentage gains. Secondly the existence of derivatives allows an investor to readily acquire a short position in an asset. For example, assume that an investor holds a bond dominated in a foreign currency and will be obliged to take position of that currency when the bond matures (long position). Assume further that he is concerned that the foreign currency may depreciate against his own prior to maturity. In order to offset this risk he undertakes to short himself by entering into a forward agreement wherein he sells the currency at predetermined rate guaranteed by the bank, thereby eliminating the risk inherent in currency movements. It is generally easier to take short position in derivative assets than in the underlying asset. Thirdly, exchange-traded derivatives can readily he more liquid and exhibit lower transactions costs than a variety of other assets. They exhibit increased liquidity owing to their standardized terms and low credit risk. As well, transactions costs and margin requirements tend to be low.

Financial Derivatives : An International Perspective

Lastly, the investor can use derivatives through financial engineering to construct portfolios which are highly specific to the needs of the portfolio objectives, such as portfolio insurance techniques (e.g., purchasing protective puts on individual stocks or stock indices) to limit downside risk.

USES

AND

MISUSES

OF

FINANCIAL

DERIVATIVES

2. The Main Economic Uses of Derivatives

2.1 Introduction: The Economic Setting

Financial Derivatives : An International Perspective

Whenever somebody buys a call option, there must be a counterparty who sells the instrument. The expense for buying the call option represents the return for the seller of the option for providing flexibility. If, at expiration, the buyer exercises the option and receives the difference between the settlement price and the exercise price as a cash inflow, this corresponds to his counterparty's cash outflow. Trivially, derivative transactions appear to be zero-sum games (transactions costs and other costs neglected). Why should zero-sum games be economically beneficial? As a matter of fact, derivatives are at best monetary zero-sum games, i.e. with respect to the involved cash flows. But the economic nature of derivatives cannot be understood by an isolated analysis of the resulting cash flows stemming from derivative transactions. If instead, derivatives are analyzed in an economic setting where, for example, risk allocation and imperfect information are relevant structural characteristics of the financial system and the economy, derivatives turn out to have strong welfare effects. As such they are no zero-sum games in allocative terms.

Evaluating the economic benefits (and later, the risks) of derivatives can not be done just by focusing on derivative markets and instruments. The question is not whether call options are attractive financial instruments or

Financial Derivatives : An International Perspective

not, but whether call options have additional benefits or risks compared to the next best alternative in the underlying cash market. As a matter of fact, many (or most) derivative instruments have close or almost perfect substitutes in the underlying cash market. Hence, the economic question is whether the derivative market system adds additional benefits or risks to the existing financial market structure.

The three basic functions of financial institutions and financial markets naturally also apply to the wide area of derivatives. Three functions are discussed in more detail:

Risk sharing and market completion;

Implementation of asset allocation decisions;

Information gathering.

2.2 Risk Sharing

Financial Derivatives : An International Perspective

The major economic function of derivatives is typically seen in risk sharing: derivatives provide a more efficient allocation of economic risks. An exporter can hedge his receipts in foreign currency with currency put options, or by selling currency forward or futures contracts. A portfolio manager hedges the overall stock market exposure by selling index futures contracts. Similarly, a financial institution hedges the interest rate gap between assets and liabilities by either buying or selling interest rate swaps.

A market is complete if the number of states (thunderstorm, rain, cloudy, sunshine) equals the number of assets with non-redundant payoffs. The principal characteristic of a complete market is that the entire set of state securities can be constructed with portfolios of existing assets. The payoff matrix of the entire set of state securities across the various states is given by the unit matrix. Within this framework, the risk of a specific security is characterized by the distribution of payoffs across states, and the allocation of risk is achieved by allocating portfolios of state securities between individuals. The economic implication of complete markets is straightforward: If there is unconstrained trading in the state securities, then individuals are able to achieve any desired risk allocation pattern in terms of payoff distributions across states.

Financial Derivatives : An International Perspective

The complete market model is a particularly important and useful framework for the analysis of the economic function of options. Ross (1976) and Hakansson (1978) states that simple options (ordinary puts

and calls on individual assets) and options on portfolios (or more generally on aggregate securities) are necessary and sufficient to complete markets and hence to allocate risks efficiently. The best intuition for this result is provided by Breeden and Litzenberger (1978) who showed how a specific option strategy can be used to manufacture synthetic state securities. Hence, the butterfly spread combines a short position in two call options with exercise price X with two long positions in calls, one with exercise price X-X, and the other with X+X. is equal to the minimum price increment of the underlying security. Then the butterfly spread creates a state security with a unit payoff in the state X, and zero otherwise.

Since the existence of a complete set of state securities is equivalent to a complete market, options in fact provide powerful tools to complete an otherwise incomplete market. If unrestricted trading in options is permitted (with respect to underlying, strategy, short selling, lending and borrowing, etc.), it will enable a efficient allocation of economic risk.

Options are therefore welfare increasing financial instruments.

Financial Derivatives : An International Perspective

Standard option pricing theory is based on the assumption that options (and other derivatives) can be replicated by dynamic trading in the primary securities. As a consequence the price of the option can be expressed as an explicit function of the (observed) price(s) of the underlying securities. However, perfect replication of payoffs requires a complete market! Now, obviously, there is a problem: either options complete the market (i.e. add new payoff structures which cannot be replicated by existing assets), or they can be priced by arbitrage (because their payoff can be replicated by portfolios of existing assets), but not both.

A solution to this puzzle comes from the fact that the replication of options requires a dynamic strategy in the underlying assets. Therefore the use of options is a substitute for the implementation of a dynamic strategy. This has an important implication: If options have the power to complete the markets (as discussed before), and because the payoff of options can be replicated by dynamic trading (under certain assumptions), it follows that dynamic trading in existing securities is a powerful way to complete the markets. This is important because it demonstrates the allocative function of active trading opportunities on secondary markets. The welfare effects of options (and with similar arguments: of forward

Financial Derivatives : An International Perspective

and futures contracts) can only be analyzed once the benefits of implementing derivative strategies under market friction, such as transactions costs or informational imperfections, are explicitly

considered. Indeed, in this case, options are not redundant assets anymore.

2.3 Implementation of Strategies

Portfolio strategies can be classified as either static or dynamic. One of the most attractive features of options lies in their non-linear payoff structure. In that way they enable a static strategy to achieve the same payoffs as dynamic strategies relying on stocks and bonds.

Static strategies represent buy-and-hold investments in stocks, bonds, options, futures, and other securities. Static strategies can be implemented easily. In order to enhance the full risk-return investment spectrum, static strategies require cheap diversification and leverage opportunities. Derivatives significantly reduce the cost of diversification and leverage.

Financial Derivatives : An International Perspective

First, derivatives are available on many aggregate economic risk factors such as global bond and stock portfolios. With many futures contacts, global risk positions and portfolios can be traded as a single financial product. While, for example, it is difficult to trade baskets of securities at stock exchanges, stock index options and futures offer opportunities to trade aggregate stock market risks for as much as 1/10 or 1/20 of the costs of an equivalent cash market transaction! Derivatives also facilitate diversification because, given that the investment represents only a fraction of the cash instrument, it is easier to diversify a given amount of capital across several assets. Moreover, derivatives often give access to asset classes, which are not available as financial investments otherwise. A good example are derivatives on commodities (crude oil, coffee, etc.) or commodity indices which offer a diversification potential which is still largely unexploited. Finally, if more risks can be diversified, the systematic risk exposure of the economy decreases which lowers the overall cost of risk capital for firms.

Second, leverage opportunities are often expensive and complicated to implement for many investors in the cash market, or are simply not feasible. However, options and futures represent (highly) levered investments in the underlying cash instruments. They require only a

Financial Derivatives : An International Perspective

small fraction of the investment in the underlying securities, while participating from the volatility of the underlying. The case is most obvious for futures, where there is essentially no initial investment except margin payments. Similarly, an option represents a leveraged investment in the underlying asset. Option pricing theory can be used to demonstrate that, under certain assumptions, the payoff of an option can be replicated by a levered, dynamically adjusted position in the underlying risky asset (for calls) or in cash (for puts). Options thus

represent leveraged assets. For example, the investment in a six month at-the-money stock index call option costs approximately 7% of the underlying index, which implies a leverage factor of 8.7. This implies that 1-(1/8.7)90% is the required percentage outside financing in the cash market which is necessary to obtain the equivalent risk exposure as with the option. In terms of market completeness and efficient risk allocation, high leverage is economically beneficial . Short positions in stocks and bonds increase the risk-return menu of efficient investments, or conversely, short selling restrictions move the efficient portfolio frontier to the right. More intuitively, levered positions and short sales allow individuals to select risk-return structures which are most appropriate to their risk appetite. Consider, for example, an investor who seeks a minimum return of 2% per annum on his investment. Once he is sure to be protected

Financial Derivatives : An International Perspective

against losses below 2%, he seeks getting maximum upside potential on his portfolio. This can be achieved by investing the present value of the desired floor in riskless bonds (provided that the riskless return is more than 2%) and investing the rest of the wealth in deeply out-of-the money call options. Of course, the overall leverage of the portfolio may not be extraordinary. But the availability of a specific, highly-levered instrument facilitates to take a risk exposure which exactly matches the risk preference of the investor, and which cannot be achieved through (static) positions in stocks and cash. However, there are indirect adverse effects of high leverage once imperfections in capital markets are explicitly considered. If investors do not have all the relevant information about the actual leverage of some instruments (e.g. hedge funds) and miss estimate their respective risk exposure, the resulting risk allocation cannot be optimal. The same is true if investors or financial institutions miss estimate their risk capacity. It is a general, but nevertheless important insight from information and insurance economics that in a world of imperfect and costly information, the aggregate risk of the society is not exogeneously given, but is substantially affected by the nature of the contracts written by the individuals to allocate risk. This is also true for financial markets. It is therefore important to notice that the potential damage of excessive leverage taken by individuals occurs primarily in imperfect markets.

Financial Derivatives : An International Perspective

Transparency and standardization of products is the key requirement to circumvent these problems. Diversification and leverage are two key functions provided by options and futures with static portfolio strategies. But, economically even more important, is their role in simplifying and acting as a substitute for dynamic strategies. The main characteristic of dynamic strategies is that the proportion of the various asset classes is dynamically adjusted according to changes in the underlying state variables such as stock prices, interest rates, etc. From an economic standpoint, options represent dynamically adjusted positions in the underlying asset and cash. The dynamic adjustment is necessary because options exhibit non-linear payoffs with respect to the price of the underlying asset. A call option written on a specific stock, for example, represents a levered position in the underlying stock. If the stock price increases (decreases) the stock exposure is increased (decreased) at the expense of additional outside financing i.e. leverage is increased (decreased). This is called a pro-cyclical strategy because the risk exposure of the portfolio is adjusted in the same direction as the value of the overall portfolio. This is an optimal strategy if the risk tolerance of the investor decreases (increases) when his wealth falls (rises). The exact nature of dynamic adjustment depends on the maturity and the exercise price of the option to be replicated.

Financial Derivatives : An International Perspective

The major advantages of implementing dynamic strategies with futures (or options) lie in their reduced transactions costs, greater liquidity and transparency. The three factors are of course related. It is known that the cost of a futures transaction is less than 10% of an equivalent transaction in the cash market. Sometimes, a futures contract represents the only way to buy and sell global risk exposures on portfolios of bonds, stocks, commodities, etc. at reasonable cost. Standardization is the major source of market liquidity in futures trading. Trading standardized futures and options contracts requires an organized market including a clearing house. Margin payments and marking-to-market reduce the counterparty risk exposure on each transaction. Furthermore, standardization of contracts traded on an exchange allows for quick execution of transactions. But the main economic effect of standardization is that it allows for heterogeneity of market participants. Speculators, traders, arbitrageurs, and hedgers with very different cash positions are forced to use the same contract, which prevents spreading out the liquidity on too many instruments. High liquidity implies low transactions costs in terms of the bid-ask-spread, and a small price elasticity of the transactions volume.

Financial Derivatives : An International Perspective

Futures contracts are also widely used for tactical asset allocation and global hedging of market risks. For example, if an investor is bullish on a specific stock (for instance, on Union Bank of Switzerland), but not necessarily on the Swiss stock market as a whole, then he can hedge the global stock market risk with a short position in stock index futures and is only exposed to the specific volatility of the UBS stock. He can do this for a relatively short time period until he is more optimistic about the overall market trend. Thus using futures contracts on global risk factors (such as stock indices, interest rates, commodities) facilitates the separation between asset selection and market timing. This is particularly important since in modern portfolio management, performance is often evaluated and compensated separately for the two components. Furthermore, the global risk position of a portfolio can be separated from individual stock characteristics. If the investor prefers stocks from the insurance industry because of tax reasons (e.g. low dividends), but insurance stocks have a very high beta and he is expecting a declining market, selling index futures and keeping the stocks has substantial advantages (in terms of transactions costs, taxes, market impact) compared to a liquidation (and later, repurchase) of the stocks. The same example can be extended to bond portfolios, where interest rate futures or swaps can be used to adjust the duration of the portfolio to the subjective risk tolerance without trading any of the bonds in the cash market.

Financial Derivatives : An International Perspective

With futures (and options) on global risk factors, individuals can adjust their risk exposure to their subjective information: If an investor has no information about individuals stocks, then he diversifies and holds the market; if he has information about a specific industry but neither on individual firms within the industry nor on the market, then he diversifies across the industry and hedges the market, and so on. Options are also widely used in tactical asset allocation. For example, an institutional investor is willing to liquidate a position of IBM stocks within the next three months, provided that the stock price goes up at least 10%. The first strategy is to do nothing and to see whether the stock price increases. However, he can also write call options on the stocks with an exercise price equal to his reservation price. In this case, he also earns the option premium. Therefore the call strategy represents a conditional sale of a cash position. The economic advantage of using calls and puts in tactical (and strategic) asset allocation is the information which is revealed by these transactions.

2.4 Information Gathering

In a perfect market with no transactions costs, no frictions and no informational asymmetries, there would be no benefits stemming from the

Financial Derivatives : An International Perspective

use of derivative instruments. However, in the presence of trading costs and market illiquidity, portfolio strategies are often implemented or supplemented with derivatives at substantial lower costs compared to cash market transactions. In this respect, the welfare effect of derivative instruments results from a reduction in transaction costs. But, this is only a part of the real economic benefit of derivatives. If risk allocation is the major function of these instruments, and because risk is also related to information, derivative markets also affect the information structure of the financial system. The information structure is a major determinant of the dynamics and the stability of the economic system. Therefore, a substantial part of the discussion about the stabilizing and destabilizing effects of derivative markets has to do with information effects. Unfortunately, the informational role of asset markets is ignored under the traditional (arbitrage) analysis of derivatives. The informational role of options is illustrated first in an ingenious study by Grossman (1988a,b). It is a well-known fact from option pricing theory that options can be replicated by dynamic trading in the underlying asset classes. A prominent example is portfolio insurance: Instead of protecting a stock portfolio with put options, a pro-cyclical strategy using cash and stocks (or stock index futures) generates the same payoff. Unfortunately, this is only true under specific assumptions, notably about the underlying information structure: The true stochastic process followed

Financial Derivatives : An International Perspective

by the underlying asset, and specially its volatility, must be known ex ante Uncertainty about future volatility is a key reason why options cannot be perfectly replicated from existing securities, i.e. are not redundant assets as assumed by the traditional option theory. Rather, it is the economic contribution of options to reveal new information which is otherwise not available in the cash market, for example information about the volatility expected by the individuals. The reason for this is that investors reveal strategic information by selling (buying) options: A portfolio insurer signals his willingness to liquidate stocks conditional on a stock price decrease (or alternatively, his preference for convex payoffs). A covered call writer signals his willingness to liquidate stock conditional on a stock price increase (or alternatively, his preference for concave payoffs). Therefore, supply and demand for puts and calls of various exercise prices facilitate the aggregation of information about the willingness of investors to buy and sell securities conditional on the price movement in the underlying cash market. This information is reflected in the options prices for the various exercise prices and maturities if the exchange has a transparent disclosure policy. It is now important to notice that this information is not available in the cash market if investors follow dynamic trading strategies instead; the mere intention to buy and sell securities conditional on the stock market evolution cannot be observed

Financial Derivatives : An International Perspective

by the market participants. However, using call and put option contracts makes this information available to all market participants. Based on this information, speculators either buy options (if they think that options are underpriced) or sell options (if they think that options are overpriced). If a speculator anticipates a sharp, but with respect to the direction unspecified price movement in the cash market, then he simultaneously buys call and put options; this strategy (called straddle) is widely used to speculate on volatility shifts. This shows that option trading processes and aggregates information about future volatility. The economic benefit of this information can be illustrated with the 1987 stock market crash: If investors would have known the volume of dynamically managed institutional assets in advance, they would have resisted to follow the same strategy, or would even have planned to do the reverse. But based on what information should they have come to this conclusion? If the same strategies would have been implemented on transparent options exchanges, the potential imbalance could have been visualized more easily by high implied volatilities: Insurance would have been very costly creating a strong incentive for writing options, thereby, the additional liquidity on the cash market on Black Monday. Thus the use of options is a way to circumvent informational externalities based on imperfect information, and that writing puts is economically identical to

Financial Derivatives : An International Perspective

providing liquidity. Hence the market liquidity is strongly (and inversely) related to informational externalities. Thus option trading reveals the demand and supply for strategies with non-linear (convex or concave) payoff structures. In contrast to the implementation of dynamic strategies, options markets provide an ex-ante mechanism to co-ordinate conditional trading in the cash market: Options prices can be used to compute implied volatilities (model dependent, however), and hedgers and speculators are able to adjust their decisions accordingly. The price system aggregates strategically important information. If, in contrast, payoffs are dynamically replicated, the strategies are based on subjective volatility assumptions which need not to be consistent with a market equilibrium - and the cash market will adjust to the equilibrium ex post by an unexpected high (or low) volatility. Intuitively, one would assume that if decisions are based on aggregate expectations (market prices, implied volatilities), the stock market evolution is likely to be more stable than if decisions are based on subjective beliefs. Therefore, the use of options to implement strategies with convex payoffs is likely to be more stabilizing.

Investors use derivatives for four basic purposes :

Financial Derivatives : An International Perspective

To hedge risk; To speculate and profit from anticipated market movements; To adjust portfolios quickly and cheaply; To arbitrage price discrepancies in financial markets.

Common Argument Against the Use of Derivatives Many stories have invaded the non-academic financial press with attention generating headlines which may actually mislead many readers. To be fair to the popular press, many of the stories written present a more balanced picture than the images conjured up by the attention glabbing headlines. For example in The Devils in the Derivatives. It is revealed that one investor, who had suffered derivative losses through an investment fund, had not closely examined that fund prior to investing when he did examine its structure but only after incurring the loses he discovered that it was a hedge fund, intended to protect against falling interest rates.This unfortunate investor , however, had been lured to the fund by impressive past performance and was not looking to hedge another position. As speculator. a result this investor became an unwitting

Financial Derivatives : An International Perspective

Still the reporting of the workings of derivatives markets has been slanted, and several unproven or misleading claims have been promoted. These range from the simple claim that they are risky investment, to the charge that speculation in derivatives has superseded traditional investing, and the arguments are: Derivative securities are risky Derivative securities create risk. Derivative securities generate volatility Derivative securities are speculative investments Derivative securities have caused speculation to displace investment. Derivative Securities are Risky This is the most common claim made against derivatives apparently based on the magnitude of the losses which the popular press has reported .Several; important points must be considered in this regard. The first is that risk is often a relative (as opposed to absolute) measure in the same way that hot and cold are relative. It is improper to categorically state that any particular security is risky, as all securities even the risk free government bonds have some level or form of risk associated with them . The level of risk must be referenced to that of another security: for example, a stock entails more risk than a government bond.

Financial Derivatives : An International Perspective

This relative risk is also dependent upon the perception of the individual, as each person has differing level of risk tolerance. That is, two people many examine the same situation and while one may assess the risk as excessive the other could view the associated risk as minimal This difference is highly dependent upon the level of knowledge and experience of the individual. To most people, walking on a high wire would be viewed as very risky. For the trained and practiced tightrope artist who might perform such a feat daily , the level of risk is not perceived to be significantly different than the average person views going to work each day. Thus a financial manager charged with dealings in foreign currencies would not likely view currency derivative contracts to be as risky as a casual investor would. Risky level is also situation specific . Generally the more significant the loss resulting from an unfavorable outcome, the greater the risk one associates with the venture. If a person while hiking the woods, came upon a small stream where the only way across was a narrow log suspended between the banks. The hiker would probably use it to cross the stream. The unfavorable out come facing the hiker is losing his or her balance and falling off the log, But, the associated loss is likely to be only a very wet pair of feet. The situation changes if that same log is suspended across a deep gorge. The unfavorable outcome is the same loosing balance and falling off the log. But now the fallout from that

Financial Derivatives : An International Perspective

event could be the loss of life and the hiker would not likely attempt the crossing. For the investor, more risk is associated with an investment where total loss would have a greater effect (such as bankruptcy than one which would represent an insignificant fraction of total wealth. Any investor must analyze the level of risk he is willing to accept, and invest accordingly. For procter&Gamble which lost U.S.$ 157 million in derivatives, the investments made were not part of its investment strategy and were in fact in violation of corporate policy. Once invested, the investor must also watch the situation because it can change ( markets are dynamic ) and the strategy must be adjusted accordingly. This may have been the trap that caught Orange Country Treasurer Robert Citron. He had successfully pursued a strategy (which had been agreed to) for several years but when interest rates initially began to rise that strategy should have been reassessed It does not appear that it was instead of cutting the loses short, they kept mounting Within a relatively short period(about nine months from the first rate increase) losses mounted to approximately U S $ 1.5 billion. Derivative Securities Create Risk Which came first the chicken or the egg.? There are many seemingly simple question which have frustrated great minds, since the beginning of time . Derivatives were created as a means of reducing risks experienced with traditional securities through hedging . But does their existence

Financial Derivatives : An International Perspective

create or increase financial risk. As derivative securities and skills in risk management have evolved. It has become apparent that many businesses are actually exposed to form of risk that in a superficial examination one would not expect to encounter. The principles of risk management quickly became relatively complex as did the derivatives used to

manage the risks. It may be that as these risks have been identified as the risk management techniques evolve one could get the impression that they are new risks hence, the creation of risk. These risks have always existed however they just were not considered to be there or were inadequately measured or understood. One argument against the creation of risk is that the hedging function of derivatives is achieved through risk transference. This means that through the derivative a risk that one person, the hedger, it is not willing to take is transferred to someone, the speculator who is No new or additional risk is created in this scenario Just the bearer of the risk changes. The investment risk that arises with a derivative contract(in a non-hedging role) is the result of future unpredictability. At the point in time that the contract is derived a spot price exists in the market. The contract specifies a price (or rate) that the agreed transaction will be performed at in the future. That future price is therefore , an estimate or prediction of the spot price at the future point in time. The future price set each day and the spot price must converge as the contract expiry date

Financial Derivatives : An International Perspective

approaches becoming equal on the final day or settlement of the contract. The risk to the non hedging investor is that the spot price in the future does not equal the estimated price made now. Derivative Securities Generate Volatility This claim is linked to the assertion that derivatives create risk, as volatility is the most accepted measure for assessing relative risk. To understand how volatility is used to measure risk one must full appreciate a basic tenet of market price movement know as the Random Walk theory. The hypothesis states that market prices of a security will fluctuate randomly about its intrinsic value and that its basic intrinsic value will not change without new input(s) This means that any specific price movement it completely unrelated to the previous move which further means that subsequent price moves are unrelated Volatility is insensitive to direction and only reflects the magnitude of problem

movements. Following any price movement the subsequent price move has equal probability of being either upwards or down wards. Volatility is linked to risk in this manner. A security with a higher volatility than another has a higher probability of a large, random price movement. Since it is just as likely that the price move would be down as up there is a greater probability of large drop in price for this security than for the one with lower volatility: hence the more volatile security carries grater risk.

Financial Derivatives : An International Perspective

The popular perception is that volatility is undesirable and this is not unreasonable given the way it is used to quantify risk However, volatility which is more specifically a measure of how quickly a security price may change is necessary for one to profit. If a security completely stable with volatility of zero its price would be unchanging an no profit would be possible. When markets advance steadily as they did through 1993, they are considered to be stable when,in fact, to change continually, they must be volatile. There is no link which shows that the use of derivatives has increased market volatilities . Derivative Securities are Speculative Investments In describing derivatives , the press has continually referred to them as bets on a movement in one direction or the other The connotation that this terms implies is decidedly unfair To address this clam. Consider a California lettuce farmer and a Canadian Supermarket chain while

keeping in mind the idea of risk transference. In the spring when the farmer plants his crop the risk that arises is that at harvest time the price for the crop may be so low that the value of the crop will be less than what it cost of plant, care for harvest and deliver it If the farmer finds that in his view that the risk is exceedingly high he will want to hedge the position. To do so the farmer can enter into a forward sale contract ( a commodity derivative) to insure that the price received at harvest will

Financial Derivatives : An International Perspective

provide a profit Commodity derivatives have long been accepted and used to manage such risks.

The forward sale contract could be arranged between the farmer and the eventual purchaser. While the farmer faces the risk of a low price. the purchaser faces the risk of a high price One might assume that if the risk of a low price is high, then the risk of a high price would be low and the purchaser should not worry. However if the market price has been rising and falling sharply and inconsistently both may view their risk as too great, and each can address their risk by arranging the forward commodity contract with each other fixing the future price of their transaction with certainy: Financial derivatives are used in exactly the same manner. If it is assumed that the forward commodity contract is denominated in U.S dollars the Canadian market will need to exchange Canadian for American currency at some point in time to pay for the crop becoming a seller of Canadian Funds. The risk to the purchaser is that between now and the commodity sale the Canadian dollar may weaken relative to the U.S. dollar making the transaction more costly . To manage this risk, the supermarket can use a financial derivative such as a currency option or futures contract to ascertain the cost of acquiring U.S. funds just as the

Financial Derivatives : An International Perspective

commodity derivative was used to fix the cost of acquiring the commodity crop. Who is a speculator? Is a speculator someone who is willing to accept higher level of risk than the average person or is it someone who enters a situation without any consideration of the risk involved? If it is the former one encounters a problem since risk is a relative measure. How does one position a cross over point between an investor and a speculator on a sliding pace? If it is the latter type of person, it is very difficult to imagine someone who would not have some preconceived notion of possible out comes. Who one person may think of as speculator, another may consider to be a very well informed investor. In general when speaking of speculators in the markets one is referring to a person who has no desire or need to hedge a position in the underlying security but only wishes to profit in changes in its price. But also consider an investor in stock which has a clam on a company s assets. Most investors would have no desire to acquire those assets but only wish to profit from changes in the stock . Speculator used only in differentiate one from a hedger on a bi polar scale, may just be a rather unfortunate choice of label. The hedger is trying to protect an existing position from incurring losses, while the speculator is establishing a position to potentially earn a profit.

Financial Derivatives : An International Perspective

The financial press has claimed that the use of derivatives has led to speculation surpassing investment as the prime motive for transactions in the financial markets. That is, the majority of transactions are gambles, rather than rationally assessed investment strategies. The logic in arriving at this assertion seems to go as follows derivatives are speculative

Derivative markets have grown faster than traditional markets and derivative volumes now exceed traditional volumes: Therefore

speculation has displaced investment. If one believes that derivatives do indeed open certain financial markets to a green population segment than it is logical that market volumes would be high. The growth should not be surprising either considering that while derivatives have been around much longer than most people believe formal organized markets for financial derivatives are relatively new. With new derivative products constantly being devised and the understanding of risk management increasing the industry could be as one would naturally expect in a growth phase of its life cycle. The growth rates may be impressive as present but one would expect moderation of the growth in the future.

Financial Derivatives : An International Perspective

RISKS ASSOCIATED WITH DERIVATIVES The following seven categories of risk have been defined in the USA by the Senate Banking Committee, Federal Reserve Board, Federal Deposit Insurance Corporation, and Office of Comptroller of the Currency: CREDIT RISK For derivatives where there is a firm commitment by the parties, credit exposure is measured not by the national amount of the contract, but by the cost to replace it in the market. Since most such contracts are made free or for a nominal fee, there is no immediate credit risk. The potential risk arises from movement of the underlying security that results in a positive value to the contract. The posibility of the counterpart reneging on the deal creates the credit exposure. Conversely, contracts that contain options have an immediate value to the seller due to the premium paid by the buyer. The buyer of these types of contracts carries the credit risk unless the value of the option is reduced to zero as a result of market movements. The seller has no credit risk. MARKER RISK

Financial Derivatives : An International Perspective

As with all financial instruments, derivatives are subject to various price risks. The market risk of derivatives is generally a function of the same risks facing the underlying security, although the extent varies considerably depending on the nature of the derivatives contract. Most institutions dealing in derivatives break market risk into its components (e.g., exchange rate risk, interest rate risk, raw material prices risk, etc.) OPERATING RISK When venturing into the derivatives market, organizations need sophisticated, high-tech dealing systems in order to maintain internal control. Without such systems. Organizations are vulnerable to errors (both accidental and deliberate) that can result in substantial losses. Included in this type of risk is the need for senior management to understand the various method employed by their treasurers. Similarly, treasurers need to be aware of the principles underlying senior managements risk-management strategy. It was the lack of protection from this type of risk that resulted in the Sterling Pounds 860 million loss to barring PLC. SETTLEMENT RISK This risk is a function of the timing of payments. If one party of a contract delivers money or assets before receiving retribution from the other party, they subject themselves to potential default by the other party.

Financial Derivatives : An International Perspective

LEGAL RISK This type of risk arises when there is doubt as to the validity of a contract. This risk is greater if the contract involves international parties and is further complicated if one of the parties declares bankruptcy. Despite the work of the International Swap Dealers Association on this type of risk, there remains an unsettling degree of uncertainty. LIQUIDITY RISK The replacement value of most derivatives contracts is based on a liquid market. However, much larger losses than anticipated can occur from a counterparty default if the markets become viscous or dry up. This can be especially true in over-the-counter (OTC) markets. AGGREGATION RISK This is also known as interconnection or systematic risk. It results from derivatives contracts that involve several markets and institutions. A default by one institution may lead to a domino effect that places the entire financial system in jeopardy. This type of risk is the basis for the world-wide financial collapse concerns of some analysts.

Financial Derivatives : An International Perspective

RECENT MISUSES OF DERIVATIVES BARINGS PLC The most recent incident making the headlines was the estimated Sterling Pound s 860 million loss incurred by the 233 year-old British investment bank Barings PLC in early 1995 a Barings derivatives trader, Nick Leeson, had positioned the bank to profit heavily if Japanese stock prices increased. As stock prices tell, Leeson attempted to recoup the losses by increasing the banks position on

Financial Derivatives : An International Perspective

the direction of stock prices. This has achieved by purchasing additional futures contracts related to the performance of the Nikkei 225 index on the Singapore International Monetary Exchange. By 23, 1995 the futures contracts represented Sterling Pounds 4.3 billion worth of Japanese stock. The gamble did not pay off. The Nikkei 225 index continued to decline and Barings was faced with mounting margin calls. When the Bank of England was informed that Barings may not be able to handle its massive exposure, the British central bank attempted to organize a rescue package. However, since the extent of the losses was determined (i.e. Sterling Pounds 610 million in Tokyo. Sterling Pounds 160 million in Singapore, and STG Pounds 90 million in Osaka). Barings was sold to ING Bank of the Netherlands for Sterling Pound 1 on the condition that in addition to its assets, ING would be responsible for all of Barings liabilities. ORANGE COUNTRY Orange County is California lost an estimated U.S. STG Pounds 1.7 billion in 1994. The loss represented 24 percent of the countys former U S $ 7 billion fund. The long time treasurer of the fund, Robert Citron, embarked on a series of relatively complex ventures involving derivatives that had a potential for very high yields if shortterm interest rates remained stable or fell. When the Federal Reserve

Financial Derivatives : An International Perspective

Board started increasing interest rates in February 1994, the countys fund experienced large losses that grew with each subsequent rate hike. The culmination of which was the December 6 announcement by the country Government that it was bankrupt. Although the county was involved in several sophisticated derivatives transactions, most of the losses were incurred through a simple financial arrangement known as a reverse-repurchase agreement whereby securities that paid a fixed rate of return were purchased on credit. The cost of credit was based on short-term interest rates. As long as the cost of credit was lower than the fixed rate of return from the securities, the fund would prosper. This strategy had been quite successful for Mr. Citron in the two years prior to 1994. PROCTER & GAMBLE (P&G) In late 1993 the treasure for P&G Raymond Mains, approached Bankers Trust New York Corporation wishing to take a position on both U.S. and German interest rates. Bankers Trust is considered among the most aggressive dealers in sophisticated derivatives. The bank gave P & G choices of instruments whose rates of return would be a function of the interaction of US and german interest rates. P&G chose the package that could deliver the greatest return: however, it also contained the greatest risk. This differential swap would profit P & G if the two countries three-year interest rates converged at a

Financial Derivatives : An International Perspective

certain pace. Unfortunately for P&G, the rates converged faster than they had anticipated. This faster than anticipated convergence cost the company U.S. $ 400,000 for each basis point. Given that a basis point is 1/100 of one per cent, the effects were devastating. Another aspect of the agreement that turned out to be quite devastating to P&G was the put options that the company gave to Bankers Trust. The put options allowed the bank to sell P&G U.S. treasury bonds and German at a predetermined price in the future. If bond price remained constant or increased, these put options would be worthless. However, as interest rates increased and bond prices fell, P&G was forced to buy these bonds at prices significantly higher than the market price. By the time P&G closed out its position with the bank in March 1994, the losses from the diff swap and the bond purchase amounted to US $157 million. METALLGESELLSCHAFT (MG) In 1992 Metallgesellschaft Refining and Marketing (MGRM), a New York subsidiary of the German commodities conglomerate MG, started negotiating long-term, fixed-price contracts to sell fuel to several gas stations and other small businesses. The agreed price for the sales was marginally higher than the current price of fuel. To hedge against the possibility of fuel prices rises (thereby obliging MGRM to buy fuel at a higher price than it had agreed to sell), the

Financial Derivatives : An International Perspective

company purchased short-dated futures on the New York Mercantile Exchange (NYMEX). As oil prices feel sharply in late 1993, the value of these futures contracts plummeted leading to several margin calls from NYMEX. MGRM requested that its parent company, MG supply the necessary funds to cover their position on the futures contracts, MG responded by replacing the management team and unwinding the futures positions. The cost of this venture into fuel derivatives is estimates at U.S. $ 1.4 billion.

ETHICAL ISSUES INVOLVING DERIVATIVES

Financial Derivatives : An International Perspective

Orange Country: Dont Blame Derivatives In December 1994, headlines trumpeted the multibillion dollar losses of the investment fund of Orange Country, California. Within a few days the

Financial Derivatives : An International Perspective

county missed a required payment on some of its outstanding debt, and several Wall Street securities dealers responded by refusing to renew the short-term loans they had made to the county. When the county could not repay the borrowed funds, the dealers began to liquidate over $10 billion of securities that they were holding as collateral; County Treasurer Robert Citron resigned; and the county declared bankruptcy - the largest local government unit ever to do so.

Much has been blamed on the derivatives in the countys investment portfolio, but derivatives were only a secondary contributor to the problem. The real fault lay with Citrons basic investment strategy: He used short-term funds to invest in longer-term securities, whose prices subsequently fell. In essence, by attempting to earn higher returns than were available from safe investments, he increased the countys exposure to interst rate risk; when interest rates jumped in 1994, that risk exposure turned into big losses. This basic problem was compounded by his use of a high degree of leverage, which multiplied the risk exposure. Despite their peripheral role in the debacle, however, derivatives image in the public mind has been so negative - equivalent to that of radioactive waste - that their mere presence created a presumption that they were the source of the problem

Financial Derivatives : An International Perspective

Citrons basic strategy was indeed risky, but not because it was particularly exotic or unusual. It had two simple components: (a) Betting that interest rates would not rise, he lent in long-term markets the investment funds of Orange County and other local government units, which were short-term in nature: and (b) He used leverage to increase the size of his bet. This strategy is not new; it is well known within the financial world. Indeed, it was the source of the original problems that wracked the savings and loan industry in the late 1970s and early 1980s. It is not normally recommended as a prudent strategy for managing the short-term cash positions of municipal governments. Why didnt anyone object to this high-risk strategy before the losses occurred? After all, Citron was not pursuing his investment policies in a closet, shielded from public view. But his early risk-taking had proved successful, and other county and municipal officials were happy to benefit from those successes. It was only after losses developed that these officials, were shocked, to learn that there was gambling going on. A contributing factor was that when the countrys luck turned sour, the initial losses were hidden by the standard accounting procedure of reporting values of assets to their original purchase cost rather than at current market prices. The Task

Financial Derivatives : An International Perspective

Governments (like business organizations) generally have some extra cash on hand. They may have tax revenues of receipts from bond issuances that have been collected in advance of being spent, and they also need a liquidity buffer to deal with unexpected variations in revenues or expenditures. Smart treasures long ago learned to generate extra revenues for their organizations by investing these idle funds. Cash is often invested in short-term, low-risk, highly marketable instruments, such as 90-day Treasury bills. Another popular strategy is to invest the funds in repurchase agreements with bond dealers. In a typical repurchase agreement, or repo, a bond dealer borrows short-term funds from investors by selling them U.S. Treasury securities but committing to repurchase the securities at a higher price the next day (or at a later date, in the case of a term repo). From the investors perspective, this is a collateralized loan to the bond dealer: The promised repurchase price implicitly determines the overnight interest rate, while the government securities serve as collateral that the lender (investor) can sell to recover the principal if the borrower (bond dealer) does not repay the loan. The problem with the very simple (but safe) strategy of investing shortterm funds in short-term securities is that the investments yield modest returns, usually only slightly higher than the rate of inflation, because they involve little risk. During 1992 and 1993, for example, the yields on

Financial Derivatives : An International Perspective

90-day Treasury bills hovered in the 3-4 percent range, and mostly toward the lower end. Anyone who wanted higher returns had to take greater risks. Citron wanted higher returns. He may have been inspired by memories of the 7 to 8 percent yields that had been earned on Treasury bills as recently as 1989. And he was surely encouraged to increase the revenues available to Orange County and to many of its constituent municipalities and school districts The Strategy The way to earn higher returns was to buy longer-term securities. Fiveyear Treasury notes, for example, often pay annual interest rats that are 1 or 2 percentage points higher than 90-day T-bills. The only problem is that they are riskynot because the U.S. Government might default on its promised payments, but because the principal is outstanding for a number of years; their market prices will fall in the interim if interest rates rise. The reason that buyers accept the lower yields on short-term instruments is that they are not exposed to the market-price risk that owning longer maturity instruments would entail. Still, investing short-term funds in five-year notes can earn superior profits as long as market interest rats dont increase. And they didnt for several years, until early 1994. So Citron invested the countys funds in

Financial Derivatives : An International Perspective

longer maturity Treasury notes and earned returns well above those that managers of other counties funds were obtaining. The extra yield available on longer instruments was so attractive that he employed another method to magnify the profits: He used leverage to augment the countys investment pool with borrowed funds. If he could borrow at the low interest cost that applied to short-term instruments and buy more higher-yielding longer-term bonds, then that spread could be added to the yield on the countrys invested funds, and Citron could look like a financial wizardat least to those who did not or (or did not want to) look any closer. How could he borrow at a lower interest cost than the yield on his investments? He could pledge the bonds in the countys portfolio as collateral and borrow against them, like a bond dealer does. Since this is a repurchase agreement from the reverse direction (in this case the bond dealer buys the bonds and lends money to the country at the short-term interest rate), the transaction is known as a reverse repo. A stylized version of Citrons strategy, with dollar magnitudes that resemble those of Orange County in 1994 is, Suppose that on December 1, 1993, Orange County had used $7.8 billion in county, city, and other municipal funds, along with $12.8 billion in borrowed funds, to invest in $20.6 billion in safe five-year U.S. Treasury notes. At that time, the most recently issued five-year notes, maturing in November 1998, yielded

Financial Derivatives : An International Perspective

51-1/8 percent interest and could be bought at par value. (Orange Countys actual portfolio was more varied and complex, but this simple portfolio would have roughly replicated its exposure to interest-rate risk and the size of the losses eventually realized on Citrons investment strategy.) The annualized interest cost on reverse repurchase borrowings was about 3-1/4 percent. The annual income from the interest earned on this hypothetical portfolio of 5-year Treasuries would have been $1.056 billion, and the annual borrowing cost would have been $0.416 billion, leaving a net profit of $0.640 billion. As an annual return on the countys $7.8 billion

investment, that amount would have been 8.2 percenta tribute to the power of leverage and an enviable figure at a time when other municipal treasures would have been earning considerably less on their portfolios: only 3 percent if they had simply bought Treasury bills, or at most 5-1/8 per cent if they had simply bought the five-year notes without any leverage. It would not be surprising that other municipalities would want to join Citrons investment pool Q and even borrow money to do so - in order to share the fruits of his financial wizardry. The Risks Normally, a reverse repo can work as Citron intended because interest rates on short-term debt are lower than interest rates on longer-term debt:

Financial Derivatives : An International Perspective

the yield curve is usually positively sloped. The risk is that interest rates will rise. When that happens, the short-term repo rate that has to be paid to finance the longer-term investment will increase, while the cash flow (income) on the longer-term instrument is fixed. Before long, more money has to be paid in interest costs on the day-to-day financing of the long-term bonds than those bonds are yielding in interest income, and the strategy begins to hemorrhage cash. The problem manifests itself gradually in terms of cash flow, but it can be seen immediately if the long-term bonds are evaluated at their current market prices: When interest rates rise, long-term bond prices fall sharply; reflecting the full value of the anticipated extra carrying cost for their remaining lifetime. That is why market value accounting can reveal financing problems such as this one much sooner than if the bonds were always carried at original cost. In the terms of the stylized example, the income on those five-year Treasure notes would remain unchanged, but the borrowing costs on the reverse repos would climb; the investment pools net income would decline or even become negative. In an equivalent fashion, the market value of the five-year Treasurys would tumble, but the fixed obligations to the repo lenders would remain unchanged, leaving a reduced net value for the Countys investment pool.

Financial Derivatives : An International Perspective

The Stylized Balance Sheet of Orange Countys Investment Fund as of December 1, 1993. Assets Liabilities $ 12.8 billion in

$20.6 billion in 5-1/8 percent Treasury notes, reverse repurchase due November 1998 3.25%

agreements (short-term) @

$ 7.8 billion in invested funds of Orange Country, etc. Revenue Implications of the Stylized Balance Sheet Income 0.05125] Interest cost Net profit Return on invested funds The Debacle Citron is leveraging strategy could succeed only if interest rates stayed stable or declined. In a rising rate environment, his strategy was destined $ 0.416 [12.8b x 0.0325] $ 0.640 8.2% [0.640b /$7.8b] $1.056 billion [$20.6b x

Financial Derivatives : An International Perspective

to produce disaster. Unfortunately for Citron (and Orange Countys taxpayers), interest rates increased through most of 1994. By the end of the year short-term interest rates were about 200 basis points (two percentage points) higher than they had been twelve months earlier, and Citrons short-term borrowing costs were engulfing the income from his investments. In early December Citrons scheme unraveled completely. Responding to rumors of their vanishing net income, some of his investorsthe constituent municipalitiesasked for their original contributions to be returned. Of course, if the fund assets were sold at their diminished current market values, not all of those contributions could be returned. Citron resigned; when the county failed on its repurchase agreements, the repo lenders began to liquidate their collateral; the county declared bankruptcy; and the scheme was over. The liquidation of the Orange County portfolio in December and January yielded a loss of about 8 percent on the value of the overall portfolio. The final dollar loss of $1.7 billion was charged entirely against the invested funds, imposing a 22 percent loss on the county and its investment allies once again an illustration of the power of leverage. This outcome was not appreciably different from the loss that would have resulted from a December liquidation of the simple portfolio.

Financial Derivatives : An International Perspective

What About Derivatives? The failure of Citrons strategy clearly did not depend on the use of exotic derivatives. Simply purchasing plain vanilla Treasury securities that were exposed to interest-rate risk and then leveraging them, at approximately 3 for 1, was sufficient. And, in fact, about three-quarters of the Orange County portfolio was composed of plain vanilla debt securities issued by the Treasury or by various federal agencies. Most of Citrons problems were caused by the interest rate risk to which all such longer-term securities are exposed. But as a way of getting even more mileage out of the countys portfolio, about a quarter of the funds were devoted to derivatives that were structured to produce higher yields and to increase in value if interest rates decreased. On the other hand, if interest rates were to rise, these securities would decrease in value even more sharply than the 5-1/8 percent note. Most of these derivatives were so-called inverse floaters: securities with varying (floating) interest rates hat pay lower yields when market interest rates rise, and vice versa. Although they sound exotic, these securities can play a valuable role as hedging instruments to smooth the fluctuations in financial institutions portfolio. For example, the income of a lender like a bank or an S&L that offers adjustable rate mortgages to borrowers will fall and rise in sync with changes in interest-rate levels.

Financial Derivatives : An International Perspective

The ability to invest also in inverse floaters that have higher interest payment when market rates fall would clearlysmooth the lenders income and thus there is a legitimate reason for banks and other financial institutions to invest in them. Other financial institutions may have liabilities that are especially interest sensitive; for them, issuing inverse floaters would have a smoothing effect. A government-sponsored enterprise, the Federal National Mortgage Association (Fannie Mae) was one such issuer, whose inverse floaters were bought by Citron. Derivatives are not radioactive waste. But buyers who buy them for speculative purposes are incurring substantial risk. It was Citrons basic strategy of borrowing short, lending long and using leverage, and not the derivatives he owned, that caused his problems. As interest rates began to rise in 1994, Citron attempted to recoup some of his losses the old fashioned way, by increasing the size of his bets. First, he increased his leverage. As late as June 30, 1993, the funds repo borrowings were only $9 billion; by March 31 1994, they had increased to the $12.8 billion . Further, in addition to the funds obtained from reverse repos, in the summer of 1994 Orange County borrowed $600 million as direct short-term county obligations that it added to the investment pool. And second, the fund invested in even longer-term securities, which would yield higher interest returns, and greater capital gains if rates fell, but would also suffer greater market-value losses if

Financial Derivatives : An International Perspective

interest rates increased. The additional $600 million, for example, was used to buy 10-year debt obligations. Were the Gambles Worthwhile? Citrons strategy was clearly one of gambling on stable or declining interest rats. When interest rates rose, his gamble turned sour, and he was cashed out. Taxpayers should not be placed at risk in this way. Still, the strategy initially did yield considerably larger returns than the safer alternatives. Those profits in the early 1990s allowed Orange County citizens to benefit from more services and/or lower taxes in those years than they would otherwise have had. Is it possible that the sum of the gains from Citrons successful gambles more than offset the losses at the end? Surprisingly, no one has asked this question. Instead, any earlier benefits from Citrons strategy seem to have been forgotten in the current outrage over the eventual outcome. The

information available at this point does not allow a firm assessment of the overall outcome, but the returns did exceed the rates on short-term safe securities by several percentage points over a number of years prior to 1994. Evaluations of the overall consequences of his strategy should include the earlier gains along with the eventual losses. The Lessons

Financial Derivatives : An International Perspective

Are there other investment disasters like this one lurking elsewhere on the horizon? With luck, not many. A few other localities have reported more modest losses from simpler (but still ill-advised) speculation. But (fortunately) none appear to have engaged in the scope and scale of aggressive leverage risk-taking that characterized Citron is strategy. Still, it is never a good idea to underestimate the general willingness to believe in free lunches. There are important lessons to be learned from the Orange County debacle, if only to reduce the likelihood of similar arising in the future:
1. The reality of the risk-return trade-off imposed by financial markets

cannot be avoided. It is a mark of the efficiency, and the underlying fairness, of well-developed financial markets that there are no viable high-return, low-risk strategies. The achievement of higher returns requires a greater exposure to risk. Of course, individuals may be lucky over a short time period; but unusually good luck in finance, as at the roulette wheel, cannot continue indefinitely.
2. U.S. Government securities are risk-free only in terms of the eventual

return of principal and interim payments of promised interest. They are not risk-free in terms of interim market-price fluctuations that accompany interest rate movements, and this can be a significant risk exposure.

Financial Derivatives : An International Perspective

3. Derivatives are not radioactive waste. If used intelligently, they can be

valuable as hedging and risk management instruments. But the ease with which risk exposure can be adjusted through derivatives makes them attractive to gambles and to naifs, who may take on inappropriate amounts of risk. Much the same trade-off of potential benefits versus potential misuse could describe most of the items in a home medicine cabinet or tool chest. Derivatives have a legitimate placeperhaps with appropriate warning labelsin the tool chest of American financial markets.
4. Better financial accounting is necessary, so that more information may

be had earlier. Most important, accountants (and their clients) must be weaned from their attachment to reporting only the historical costs that delay the recognition of bad news, and should focus instead on

current market values. If Citron had been required to report the current market value of his portfolio on a frequent basis, his losses would have been noticed much sooner, and the damage might have been considerably lessened.
5. The financial literacy of government officials and of voters generally

needs to be raised. The fact that the elected county supervisors of a prosperous county of 2.6 million residents did not recognize and challenge Citrons gambles is strong support for this proposition.

Financial Derivatives : An International Perspective

6. Voters mush hold their elected officials to higher standards. It was the

voters of Orange County who elected Citron to the post of County Treasurer, and re-elected him in November, 1994.
7. The media need more financial savvy to report effectively on complex

financial topics. Editors would be unlikely to assign untrained reporters to cover sports events or to provide science coverage, but they casually assign untrained reporters to report on financial events. If the electorate is to vote more intelligently, if elected officials are to be held to a higher standard, the press must report financial news more accurately and with greater depth and sophistication. Derivatives are an increasingly common element of the financial landscape; they need to be better understood. Despite the built-in interest value of yet another terrible derivatives-related scandal, it is neither correct nor helpful to blame derivatives for every investment debacle that may occur.

Financial Derivatives : An International Perspective

DERIVATIVE IN INDIA : A FRAMEWORK OF ECONOMIC PURPOSE


Introduction Appointment of the Committee

Financial Derivatives : An International Perspective

The Committee was appointed by the Securities and Exchange Board of India (SEBI) by a Board resolution dated November 18, 1996 in order to develop appropriate regulatory framework for derivatives trading in India. While the Committees focus is on equity derivatives, it has maintained a broad perspective of derivatives in general. Before prescribing a regulatory framework for derivatives, the Committee feels that it is necessary to examine how derivatives fit into the framework of economic purpose. Committees main conclusions The Committee is strongly of the view that there is urgent need for introducing equity derivatives in India from the viewpoint of market development because the Indian market lacks hedging facility against market risk to which equity holders are exposed. The hedging facility has become necessary for institutional equityholders, such as mutual funds and other investment institutions equityholders, such as mutual funds and other investment institutions, which have been accumulating equity portfolios. Futures trading through derivatives may be appropriately phased, starting with stock index futures. Apart from protecting financial institutions, the introduction of stock index futures will enhance the efficiency and liquidity of the cash market in equities through arbitrage transactions. It will also create pressures for reforming the cash market. The Committee feels that the cash market system in Indian equities would have to be purged of certain crucial weaknesses if it is to serve as a solid base for index future.

Financial Derivatives : An International Perspective

As there has been considerable controversy surrounding derivatives, the Committee has closely examined all aspects of the introduction of equity derivatives, including the nature and uses of he various derivative products, and the opinions of potential market participants (including hedgers and speculators). In the Committee opinion, both the cash and the futures market would undoubtedly have to be subjected to stricter discipline once the futures trading starts. Financial Derivatives Types The Committee is mainly concerned with equity - based derivatives but it has tried to examine the need for derivatives in a broad perspective for creating a better understanding and showing inter-relationships. Broadly speaking, financial transactions and asset-liability positions are exposed to three kinds of price risk viz. a) Exchange rate risk (where the position involves a foreign currency, as in the case of imports, exports, foreign loans and investments). b) Interest rate risk (as in the case of fixed-income securities, like treasury bond holdings whose market price could fall heavily if interest rates shot up)., and c) Equities market risk, also called systematic risk, (which cannot be diversified away because the stock market as a whole may go up or down from time to time). Futures vs. Forward contracts

Financial Derivatives : An International Perspective

The Committee favours the introduction of futures wherever possible. As both forward contracts and futures contracts can be used for hedging. Moves to wards futures in India Forward contracts are presently being used in India to provide forward cover against exchange rate risk. There are no financial futures in India at present. The Committees recommendations, if accepted, will result in the establishment of the first financial futures market in India. Currency and interest rate futures, which the RBI is considering, may also arise alongside. The feasibility of an effective future market in any asset depends on certain preconditions, particularly the existence of a well - developed and active cash market. Even where a futures market exists, forward contracts are not ruled out and can continue to be used for small transactions or where a tailored contract is desired. Choices of derivative instruments In regard to equity derivatives, the Committee considered both stock index derivatives and individual stocks derivatives. Survey of potential participants Through a questionnaire-based survey, among potential users of financial derivatives in India, such as mutual fund, other financial institutions, commercial banks, investment bankers, and stockbrokers, the Committee explored the likely, nature of potential demand for equity derivatives of each kind. Interestingly, the survey findings placed index futures much higher than individual stock futures in terms of both priority and desirability. The order of

Financial Derivatives : An International Perspective

over-all preference in India, according to the Committees survey, is as follows: 1. Stock Index Future 2.Stock Index Options 3. Individual Stock Options and 4. Individual Stock Futures Stock Index Futures : most preferred derivative There are many reasons for preference of Stock Index Futures, some of the advantages are: Institutional and other large equityholders think in terms of portfolio hedging mainly. Index futures are the most cost-efficient hedging device. Hedging through individual stock futures is costlier. Stock index cannot be easily manipulated whereas individual stock price is manipulated easily, more so in India. This is partly because an individual stock has a limited supply which can be cornered. Even large companies in India, like Reliance Industries Limited and State Bank of India have complained about their share prices being manipulated by certain interested parties. The supply of stock index contracts is unlimited and rules out any possibility of cornering. Of course manipulation of stock index can be attempted by influencing the cash prices of its component securities but the possibility by influencing the cash prices of its component securities but the

Financial Derivatives : An International Perspective

possibility of such manipulation is not high and is minimised by designing the index carefully. Stock index futures are more liquid and more popular than individual stock futures. The responses to the Committees questionnaire points to the same. Stock index, being an average, is much less volatile than individual stock price . This implies much lower capital adequacy and margin requirements in the case of index futures than in the case of individual stock futures. Since there has to be clearing house guarantee the risk of the clearing house going bankrupt is extremely remote in case off index futures trading. Futures on individual stocks can be used as a vehicle for manipulating their prices in the cash market. In the case off individual stocks , the positions which remain outstanding on the expiration date have to be settled by physical delivery. This is an accepted principle everywhere. It is necessary for ensuring that futures and the cash market prices remain firmly tied to each other. In the case of index futures, physical delivery is impractical. Index futures are cash settled all over the world on the premise that the index value is derived independently from the cash market and can be safely accepted as the settlement price. Regulatory complexity is likely to be less in the case of stock index futures than for other kinds of equity derivatives.

Strategic uses of index futures by institutions

Financial Derivatives : An International Perspective

It was represented to the Committee by mutual funds and other financial institution that they were handicapped in their investment strategy because of the non-availability of portfolio hedging facility in India. They need derivatives not for generating speculative profits but for strategic purposes of controlling risk or restructuring portfolios. Given below are some practical examples from a presentation made before the Committee by some institutional

representatives: Reducing the equity exposure in a mutual fund scheme : Suppose that the UTI decides to reduce its equity exposure in the US-64 Scheme from, say, 40% to 30% of the corpus. Presently, this can be achieved only by actual selling of equityholdings. Such selling entails three problems : first it is likely to depress equity prices to the disadvantage of the UTI and the whole market; second, it cannot be achieved speedily and may take some months, and third it is a costly procedure because of brokerage etc. The same objective can be achieved through index futures at once, at much less cost and without disturbing the cash martet. The UTI may immediately sell index futures, thus leaving the cash market undisturbed. The actual sale of equityholdings may be done gradually depending on market conditions in order to realise the best possible process. As unloading of the holdings progresses, the index futures transaction may be unwound by an opposite transaction to the same extent. Investing the funds raised by new schemes; When a new scheme is floated the money raised does not get fully invested for considerable time. Suitable securities at reasonable prices may not be immediately available in sufficient quantity. Rushing to invest the money is likely to drive up prices to the

Financial Derivatives : An International Perspective

disadvantage of the scheme. Timing is important in the case off equity schemes. If the scheme is launched to take advantage of low equity price, such advantage may be lost due to delay in acquiring suitable securities as the market situation may change. The availability of stock index futures can take care of this entire problem. Partial liquidation of portfolio in case of pen-ended fund : In the case of an open ended scheme, repurchases may sometimes necessitate liquidation of a part of the portfolio there are problems in executing such liquidation.

Selling each holding in proportion to its weight in the portfolio is often impracticable. Some of the holding may be relatively illiquid. Rushing to the cash market to liquidate would drive won proves. The price. The price actually realised may be different from the price used in NAV computation for repurchase. The timing of liquidation may not be right because of market depression. Stock Index Futures can help to overcome these problems to the advantage of unit holders. Preserving the value of portfolio during times of market stress : There are time when the main worry is the possibility that the value of the entire equity portfolio may fall substantially if say, event X occurs. Sale of Stock Index Futures can be used to insure against the risk, Such insurance is specially important if the account s closing date is nearby because the yearly results will get affected if the risk materializes. Stock index futures can neutralize such risk. International investors : The buying and selling operations of FIIs presently cause disproportionate price - effect on the Indian equities market because all transactions are through the cash market only. This is an important factor

Financial Derivatives : An International Perspective

making the Indian equities market highly volatile from day to day. The FIIs buying/selling is aimed at either increasing or reducing their exposure to the Indian equities market. In other words words, what the FIIs buy/sell is a piece of the whole Indian equities market. If stock index futures are available, this can be carried out with greater speed and less cost and without adding to market volatility. The FII flows show sudden changes from time to time. While trying to maximise the net inflow of FII portfolio investment, its disturbing effects on the cash market for Indian equities will be minimised by making available stock index future. The availability of such a hedging device is likely to increase the international investors appetite for Indian equities. Mutual funds in India are presently restrained by the regulations from using derivatives even for hedging purposes. The regulations need to be changed appropriately. While prohibition on the use of derivatives by mutual funds should be withdrawn, the Committee feels that it is necessary to ensure that derivatives are not used by mutual funds purely for speculation. The Trustees of each mutual fund should be required to lay down a formal policy and detailed rules about what, how and within what limits, derivative products may bee used for purposes of any scheme and the authorisation procedure. In the case of mutual funds, the use off derivatives should be for risk reduction or for strategic portfolio restructuring. Of course, there have to be disclosure requirements in the offer document of the scheme concerned. Cash Market Strengthening : Crucial Pre-requisite The Committee agrees with the universal proposition that a pre-requisite of an effective futures market is the existence of a strong cash market. After all,

Financial Derivatives : An International Perspective

derivatives, whether related to commodities or financial assets, derive their value from the cash asset. Introduction of futures trading should be preceded by a review of the cash markets working to determine any particular weaknesses which may affect the effectiveness of the futures market. In order that fundamental factors are able to exert their full influence on price formation, the cash market should be a true cash market, i.e. delivery-based. A cash market without deliveries is not a true cash market. The constant feed-back between the cash market and the futures market through arbitrage can be expected to keep the two in alignment with each other and to ensure that prices in both markets remain tied to underlying fundamental factors. Cash market weakness The Committee like to draw attention to the need for removing the following weaknesses of the Indian equities market in order to provide a solid foundation for a futures market. Mixing of cash AND forward transactions Traditionally, the Indian equities market has been a queer mixture of cash and futures market, in which cash transactions involving delivery (all institutional transactions are of this kind) and futures transactions with no intention of delivery are conducted simultaneously without being

distinguished. In fact the dominant transitions are the non-delivery transactions (which are the equivalent of futures / forward transactions). In

Financial Derivatives : An International Perspective

the most active scips, deliveries are just around 5 per cent of the trading volume : in many others, around 20-30 per cent. The market community in India is used to this traditional system for so long that it is unable to recognise its illogic and adverse effect on the markets economic efficiency. A mixed cash-cum-carry forward system is not a very sound basis for creating a futures market because (a) the carry forward system has no transparency (b) the influence of fundamental factors is greatly weakened due to dominance of short term speculation and (c) creating a futures market on such a basis may have the effect of compounding the existing weaknesses. In fact, studies have shown Indian equity markets behavior to be bordering on bizarre or diverging from fundamentals and highly volatile. This is the result of mixing of cash and forward trades. All over the world, re-engineering of stock markets has aimed at clearer separation between cash and futures markets, instead of mixing them. Separation promotes the markets economic efficiency. This has led to the adoption of the rolling settlement system because such a system ensures that cash markets will function as genuine cash markets. The system, of course permits borrowing and lending of securities, but no carry forward. Not even futures markets permit carry forward from one settlement to another in the way proactive in India. The traditional Indian trading system in stock exchanges was originally patterned on the lines of the U.K. system. The U.K. has shifted to rolling settlement recently. However, even earlier, its fortnightly settlement system

Financial Derivatives : An International Perspective

always emphasized settlement by delivery, unlike in India. It is true that the London Stock Exchange (LSE) has contangos (equivalent to carry forward trades) but according to information provided by LSE authorities contangos were negligible. Also according to the same source, the squaring up or closing business (i.e. offsetting of buying and selling transactions within the same settlement) in London accounted for only about 5% of customer business whereas the bulk of Indian trading is of squaring up kind. Difference in trading cycles among stock exchanges If all stock exchanges were on rolling settlement system, it would not have been a problem. Indian stock exchanges now mostly have a weekly trading cycle but the cycles are not uniform. For example, the weekly trading cycle on the NSE is from Wednesday to Tuesday and on the BSE from Monday to Friday. Because of the difference in trading cycles, brokers having membership of both the exchanges earn from circulating their trades continuously from one exchange to the other without ever having to deliver. Speculating clients can do likewise by engaging on e broker from NSE and another from BSE. Such circular trading is a complete travesty of the cash market and an abuse of he market system, made possible simply by deliberately keeping the trading cycles different. It has been encouraged by low brokerage [as low as (0.02-0.05 per cent)] on such non-delivery trades. It appears that stock exchange members have acquired a vested interest in keeping trading cycles different in order to deliberately generate arbitrage opportunity. As the expiration dates for trading cycles differ by a few days between exchanges, prices for the same securities on two exchanges tend to differ often by 0.5-1.5 per cent. The price difference on the expiration day of

Financial Derivatives : An International Perspective

trading cycles is larger than on other days. The Committee feels that keeping trading cycles different among stock exchanges is serving only the interests of speculators and not that of genuine investors nor of market development. As explained above, the differences in trading cycles spoils the character of the cash market. Stock included in the will -known stock indices are traded on both NSE and BSE. If process on these two exchanges are not the same, it creates a tricky situation as the value of the same index, if computed seperately from NSE and BSE prices, may not be the same. The questions is which value should the futures market track ? The Committee suggests that serious consideration should be given to implement a uniform trading cycle among all exchanges till such time as the rolling settlement can be adopted in India. This will be an important step towards achieving a coordinated but pro-competitive nationwide market. It would greatly benefit genuine investors and enhance market liquidity. It would also eliminate circular trading which has become a rampant evil. The reform is being recommended so that the cash market can provide a sound and reliable basis for creating a futures market. Weakness of stock exchange administrative/monitoring machinery The Committee members are emphatic that derivatives trading would require much more stringent monitoring and much higher standard of discipline that what the tradition has been in Indian stock exchanges. Much has been done by SEBI to improve matters in this respect. Much more still remains to be done specially in the direction of ensuring that the enforcement machinery

Financial Derivatives : An International Perspective

within stock exchange is independent from control of trading members. The position of the Executive Directors of stock exchange vis-a vis the elected members of the Board of Directors of stock exchange also needs to be further strengthened. Depository system inadequacy The Committee has considered whether all the securities composing a stock index, used for index futures, should necessarily be in depository mode. It is recognized that while index-based derivatives trading does not itself involve deliveries it gives rise to arbitage transactions between the index derivatives market and the cash market. Settlement problems of the cash market have the effect of impairing and weakening the arbitrage process by making it risky and costly. The arbitrage mechanism keeps the two markets in alignment. For this reason, it is highly desirable to have all the scrips of the particular index in the depository mode. However, it is felt that this need not be insisted upon as a prior condition in order to avoid delay in the introduction of derivatives trading . What is needed is acceleration of the progress of the depository system which has already been put into place. Of course trading futures and options on individual scrips should b e allowed only if the scrips in question are in the depository mode.

Financial Derivatives : An International Perspective

PROCTER &GAMBLE
Procter and Gambles (P & G) reason for entering into its leveraged swap with Bankers Trust (BT) was to achieve lower funding costs. It wanted floating rate funding at 40 basis points (bp) under the rate available on US commercial paper (CP) because they had achieved this target with a swap that was maturing. Bankers Trusts rocket scientists were happy to oblige P & Gs demands, but in so doing piled on risks, some of which and others obscured. Although P & G had stated that it wanted funding at 40 bp below CP, BT offered it funding at 75 bp below CP. The terms of the $200 million five - year swap executed on November 2, 1994 were : BT paid P&G a fixed rated throughout the life of the five year swap and in return, P&G paid BT a floating interest rate 75 bp below CP of the first six months of the swap. For the remaining 4 1/2 years of the swap, P&G would pay BT 75 bp below CP plus a spread ( Figure 1). This spread was to be set at the end of the six months i.e. 2 May 1994. The formula on this spread was : Spread = (98.5 [ five-year CMT yield ] / 5.78% - 30 year Treasury Price) / 100 where CMT stands for Constant Maturity Treasury. But there was a floor of zero bp to this spread, so even if the formula retained a negative spread, P&G would not pay BY CP minus 75 bp minus spread. Table 1, shows different spread levels depending on five-year CMT yields and 30-year Treasury process. If interest rates did not move during the six month period (i.e. five year CMT yields remained at 4.95% and 30 - year were obvious

Financial Derivatives : An International Perspective

Treasury prices at 103.02%), the spread would be negative 1830 bp, come spread -setting day in May 1994. But P&G would never have enjoyed paying no interest to BT. If rates had gone up by 40 basis points during that sixmonth period, resulting in a negative spread of 644 bp, P&G was still committed to paying CP minus 75, not CP minus 75 bp CP - 75 bp (for the first six months) then CP - 75 bp + swap spread for 4.5 years

Bankers Trust

Procter & Gamble

Fixed rate Figure 1 Procter and Gambles Leveraged Swap. Table 1. Procter and Gambles Leveraged Swap: Extra Dollar Payments Due Solely to Spread Coming into Operation. (Assume that both five-year CMT yields and 30-year Treasury yields increase by the same amount, i.e. parallel shifts of he yield curve). Five-yr. CMT 30-yr yields (%) Treasury price (%) 4.95 103.02 -1905 -644 -49 +243 +535 31 31 31 31 Spread (bp) Leverage Net spread (bp) -1830 -569 -124 +168 +460 $1.5M $1.5M $1.5M -$3.36M -$9.20M $ equiv

(per year)

5.35 (+40 bp) 97.61 5.55 (+60 bp) 95.07 5.65 (+70 bp) 93.85 5.75 (+80 bp) 92.64

Financial Derivatives : An International Perspective

5.95 bp) 6.45 bp)

(+100 90.30

+1110

30

+1035

-$20.70M

(+150 84.86

+2505

29

+2430

-$48.60 M

Notes to table : 1. Calculations are based on Treasury yields and prices provided by Bloomberg. 2. The leverage is obtained by dividing the spread derived from the formula a d the increase in five-year CMT yield. 3. This dollar amount is not the net coupon payment per year on the swap. Such a dollar amount would have to take into account the fixed rate BT pays P&G as well as the existing CP rate The fixed rate is constant throughout the life of the life of the swap. P&G would pay the existing CP rat whatever it was so the only variable dollar amount was that due to the 5/30 spread. The dollar equivalent here shows the annual interest cost resulting solely from the spread.

minus 644 bp. P&Gs cheapest cost of function under this swap was CP minus 75 bp because BT had incorporated a floor of 0 bp in the payout formula. But as Table 1, shows, if rates rose by 70 basis points or more during those vital six months, then P&Gs floating costs would increase significantly. For example a 100 bp increase resulted in a net spread of 1035 bp (1110-75) being added to the CP rate. It is clear therefore that P&G faced significant interest rate exposure if interest rates rose between November 1993 and May 1994.

Financial Derivatives : An International Perspective

Because this spread formula was ostensibly a play on 5 and 30 year Treasury yields, this swap came to be known as the 5/30 swap. Yet the predominant risk of this structure came not from whether the spread between 5 and 30 year yields narrowed or widened, but from a general rise in US interest rates due to the embedded leverage in the payout formula. The spread play between 5 and 30 year Treasuries was secondary to the payoff profile and risks of the swap. The leveraged play in this transaction came from two fronts. First, any change in five-year CMT rates was magnified 17 times (derived from dividing 98.5 by 5.78). Second, because it was the 30-year Treasury price rather than the yield that was subtracted from the five-year CMT yield, there was extra leverage coming from this side of the equation too. Because the price of a bond declines when interest rates (yields) rise and advances when rates (yields) fall, so the spread in this formula could only increase with every upward move in US Treasury yields since there was the simultaneous effect of five - year CMT yields rising and 30-year Treasury prices dropping. (The only way the spread could have decreased in the wake of US rates rising is for 30-year Treasuries to react inversely to a rate hike i.e. their yields fall (and prices rise) when interest rates increase, which goes against all fundamental of fixed income investments.) The flip side this statement was, if interest rates had fallen, then the spread could only decrease but that was immaterial to P&G because its minimum cost of funding under this swap was floored at basis points below CP. Financially, P&G would not have been any better off. Its maximum benefit from this leveraged swap was $1.5 million per year ($200 mn x 0.0075).

Financial Derivatives : An International Perspective

It is also no coincidence that the spread involved a 30-year Treasury - in the US Treasury family, these long-dated instruments have the highest duration and are therefore the most sensitive to changes in interest rates. At the time the swap was executed 30-year US Treasuries had a duration of about 11. Table 1. shows the risks to which P&G were exposed. The five -year CMT rate at the beginning of November 1993 was around 4.95% and the on-the -run 30-year Treasury had a price of about 103.02%. The table shows the spread calculations for various levels of five - year CMT rates. It shows very clearly that P&G could only afford a 70 bp rise in five-year CMT yields before it got blown out of the water. The leverage made the spread formula hypersensitive to changes in US interest rates since each basis

point move was magnified up to 31 times. Then question arises why did Bankers Trust incorporate this spread into the swap cash flows? Why was P&G prepared to take on such risks ? Because there is no free lunch. P&G could not achieve its funding target by executing a plain vanilla interest rate swap. To achieve such off - market rates it has to assume some risks. It did so by selling a put option on 30-year US Treasuries whose payoff profile was repackaged into the spread formula. The premium it earned for selling this option was 75 basis points per year for five year which option specialists say was inadequate compensation for such an option. It rates stayed low within that six-month period, P&G would pocket the full premium and enjoy cheap funding. The maximum gain of $7.5 million for the term of the swap compared with unknown interest rate costs if US rates rose shows the risk run by option sellers who do not hedge their positions.

Financial Derivatives : An International Perspective

P&G knew the huge risks. It knew it had breathing space of only 70 bp because the option was so hyper-leveraged. But it also knew that the premium it earned from selling this highly-leveraged option was 75 bp

compared with its funding target of 40 bp below CP. This was the base-line premium it needed to earn . P&G was in a conundrum : it could sell the six month option pocket the premium an d take it on the chin if interest rates rose between November and May. On the other hand it could try to manage the risks of this option by locking-in early - i.e. canceling the option sale so that BT could not exercise it - if market conditions become less rosy. There were two ways P&G could cancel this option sale - buy it back from BT or buy an offsetting put option (with roughly identical features) from another investment bank, which may have been tricky given that liquidity inn customized products is limited. But for the transaction to make an economic sense in the first place, P&G had to satisfy itself that it cold buy back the option at a cost of no more than 35 bp premium per year (so it could still meet its sub-CP funding target of 40 bp). For the event to materialize, a few basic conditions had to be satisfied The only way the six month put option could decline in value was for interest rates to fall so that the option went further out of the money or for volatility and interest rates to remain stable so that the time decay on the option eroded its value. The faster this time decay the earlier P&G could buy back the option and lock in its funding costs P&G thus needed an option whose time decay was front-loaded. It finally sold BT an option that was al out-of -the- money on a forward basis that, when the deal was executed, the option had no intrinsic value and only time value, (The strike price of an options often compared to the implied forward rate of he

Financial Derivatives : An International Perspective

underlying asset, as opposed to the sport rate, because both buyers and sellers are more concerned about rate levels near or at the options expiry date rather than rates prevailing at the start of the deal.) Consequently, 80% of he options time decay was concentrated in the first three months of its life. However if rates and volatility did not remain stable, then P&G had no hope of buying back at a cheaper price the option it had sold to BT, or buying another put option form the street at a price less than what it earned fro selling the original option. Because the option was so hyper-leveraged, interest rates did not have to move much before the option zoomed into - the - money; dashing all hopes of buying it back cheaper, or locking -in. It is still not clear why P&G chose to sell a six-month option for 75 bp and then lock-in. Why did it not just make life simpler for itself and sell a shorter maturity option for 40 bp premium? That would have enabled it to achieve its sub-CP funding target, Or did P&G want its cake and eat it .. did it like the idea of possibly earning 75 bp premium but locking in when it wantted to? P&G insisted it did not have any proper information on how this lock - in price was calculated. Its court filings (P&G is suing BT) say. P&G entered the [5/30 swap] because, in response to P&Gs repeated questions < Bankers Trust falsely assured P&G it would be protected against significant loosed from rising interest rates because P&G could safely lock in its rates if interest rates began to rise. When rates did rise, Bankers Trust changed the rules, imposing on P&G a lock-in interest rate calculated under a secret, proprietary, complex, multi-variable pricing model with Bankers Trust would not share and to this day has not shared with P&G.

Financial Derivatives : An International Perspective

If locking-in just meant P&G buying back the option which it has sold too cheaply in the first place, then it is no wonder that BT Could not price the lock-in in advance since that meant quoting a fixed option price, which was impossible given that option values fluctuate with changing market conditions. Even if BT has given P&G indicative prices they would be useless because these prices would not be valid as soon as there were changes in the variables that went into the pricing of this option. If the company did not understand the mechanics of this lock-in mechanism - knowledge vital to how it managed the almost open-ended exposure of this transaction - then it took on risks it did not fully appreciate when it executed the swap.

Financial Derivatives : An International Perspective

GIBSON GREETING

In November 1991. Gibson executed two plain vanilla interest rate swaps with Bankers Trust. Both had notional amounts of $30 million ore had a maturity of two years while the second had a life of five years. The two - year swap had Bankers paying Gibson six - month LIBOR while Gibson paid Bankers a fixed rate of 5.91% The five - year swap had Bankers paying Gibson a fixed, the rate of 7.12% and receiving six - month LIBOR payments (see Figure 1. In effect, the two LIBOR payments cancel each other out so the Gibson effectively earned the difference between 7.12% and 5.9% for two year. This interest rate revenue of 1.21% effectively reduced its interest rate cost on its $50 million bond issue. However, in mid-July 1992 both parties canceled both swaps with Gibson making a profit of $260 000. After that Gibson executed a ratio swap within three months of the first two swaps being canceled . Ratio Swap

Financial Derivatives : An International Perspective

Under this arrangement Gibson paid a floating rate of LIBOR squared divided by six, in return for receiving a fixed payment of 5.5% from Bankers Trust. the Five-year swap for a notional $30 million and interest payments were to be exchanged every six months ( Figure 2). Gibsons first two LIBOR payments were set at 1.581% and 1.893% respectively so in the first year of the swap, Gibson was a net receiver of funds. Yet, less than 90 days after it entered into the ratio swap, Gibson was told that swap had a negative value of $975000. figure 2 Towards the latter part of the swaps tenor the swap was amended three time (within a space of ten days), each time to shorten the maturity. It was finally canceled on 21 April 1993 Just six months after both parties had entered into ratio swap. Periodic Floor Running concurrently with the ratio swap were two other derivative deals the periodic floor and Treasury spread lock. In the periodic floor. BT paid Gibson six month LIBOR plus 28 basic points, while Gibson paid BT six month LIBOR flat, a long as the six - month LIBOR rate was not more that 15 basis points lower that the LIBOR rate . The periodic floor was cancelled nine months after its initiation and its monetory obligations rolled into a time swap and amended knock out call. Spread Lock 1

Financial Derivatives : An International Perspective

On 11 January 1993 the two parties entered a $30 million five-year spread lock swap. Under this swap, Bankers would pay Gibson a coupon which was the sum of the mid-market swap spread and the on-the-run Treasury rate while Gibson paid Bankers a coupon equal to the sum of the spread lock and the off-the run Treasury rate. This spread lock was initially set at 38 basis points . Figure 4 This swap was amended nine times before it was finally cacelled a year after it was entered into and before any payments were exchanged. The first amendment on 16 April 1993 changed the off-the -run Treasury rate to the ten-year Treasury rate. The next three amendments, all taking place within a space of three weeks changed the spread lock from 38 bp to 36bp, to 51 bp and to 56 bp. On 22 September 1993, Bankers Trust and Gibson amended the spread lock 1 swap (and another spread lock 2) in exchange for linking an option wedding band 3, to the two spread lock structures. Treasury-Linked Swap Gibson entered into this transaction in return for BT shortening the maturity on the ration swap from five to four years.One the face of it, the treasurylinked swap looked good for Gibson. It was to pay BT LIBOR and receive LIBOR plus 200 bp in return. But principal repayment at maturity was determined by a highly-leveraged formula which magnified by 21 times

interest rate changes in the two year. treasury yield ( figure 5). The principal exchange terms required gibson to pay bankers. Trust $30 million. while

Financial Derivatives : An International Perspective

Bankers would pay the lesser of 4 30.6 million or an amount determined by the following formula: [ $30000000 x (1-103 x 2 year treasury yield) /4.88 - 30year Treasury price] / 100 Figure 5 spread lock 2 Spread lock 2 was entered on 6 May 1993, but the first interest payments would only be exchanged two years hence. the structure was similar to spread lock 1. which both parties had entered only four months ago. the only difference was the size of the spread which was set at 31.5 bp. $30 million notional, maturity eight months Amount X or $ 30.6 million whichever was the lesser

LIBOR Bankers Trust LIBOR + 200 bp Gibson

$30 million

Financial Derivatives : An International Perspective

Key principal flows at maturity

This swap agreement was amended

eight times before it was finally

cancelled nine months after the two had entered into the swap. Most of the amendments were to change the size of the spread lock. But the main amendment on 22 September 1993. also involved spread lock I which as recounted earlier, was to incorporate an option, wedding band 3 into the structure. Wedding Band 3 Wedding band 3 changed the payout obligations on spread lock 1 and 2 . Under this structure the spread lock payout was 48 bp plus a spread. But whether the spread came into operation depended on the level of six month LIBOR on each London business day from and including 24 September 1993 to 24 September 1994. if LIBOR was between 3-5% the spread was zero so the minimum spread lock of 48 bp came into effect. If LIBOR was outside that band, the minimum spread in the spread-lock was determined by the following formula (LIBOR - 3.75%) x 0.85, where LIBOR was the LIBOR rate on 24 September, 1994 . This agreement was amended once a month for its four month existence, it was cancelled on 14 January 1994 and both parties entered into a time swap. $30 million notional maturity 51/2 years. 10 years Treasury rate + spread lock

Financial Derivatives : An International Perspective

(spread lock : 48 bp points + spread)

Breakers Trust All -in- rate

Gibson

Knock -Out Call option On 10 June 1993, Gibson bought a knock out call option to help it reduce its exposure on the Treasury linked swap because it realized that it would be paying out far more principal than it would be receiving under the latter structure . With the knock out call option, Bankers was required to pay Gibson on settlement date an amount calculated as follows (6.876% - yield to maturity of 30 year Treasury security)x 12.5 x 4 25000.000. the payout of this option leveraged by 12.5 times, any changes in the difference between 6.876% and the yield of a 30 year Treasury so that if interest rates did decline. Gibson would be paid off handsomely by bankers Trust. The trouble was that the call had a knock out strike of 6.48% once 30 year . treasury yields remained stable Gibsons chances of exercising the option before it was knocked our were slim because it was only exercisable on maturity(Figure 7) . Premium upfront Breakers Trust Gibson

Financial Derivatives : An International Perspective

$25 million x 12.5 + (6.876% yield at maturity of 30 years treasury Figure 7 Knock out call option Time Swap In the time Swap, bankers Trust paid Gibson six month LIBOR plus 100 bp while Gibsons floating payments to bankers depended on LIBORs level during the swap ( Figure 8) The formula for Gibsons floating obligations was as follows, six month LIBOR + (Nx0.5), where N is the number of days in a calculation period that the six month LIBOR rate tell outside the designated range. the pre -agreed calculation periods and designated ranges were as follows. 6 August 1993 - 6 February 1994 6 February1994 - 6 August 1994 6 August 1994 -6 February 1995 3.1875% - 43125% 3.2500% - 4.500% 3.3750% - 5.1250%

6 February 1995 - 6 August 1995 3.5000% - 5.2500% Under the terms of this swap. Gibson was betting on interest rate stability that six month LIBOR would stay within narrow bands of less than 1% for the first two years, and larger bands thereafter. if this scenario materialized Gibsons floating rate obligations would be equal to six month LIBOR. If interest rates were volatile (they did not need to be trending upwards or down wards), and spiked below or above the upper and lower bands. Gibson would have to pay and spread above LIBOR every time the bands were breached.

Financial Derivatives : An International Perspective

The first two amendments, occurring on 12 August and 25 August t1993 (the swap was only entered into on 4 August 1993) increased the multiple form 0.5 to 0.65, and from 0.63 to 0.75. (Six month LIBOR + N) + 05 Bankers Trust (Six month LIBOR + N) + 05 The Ten commandments Before considering a derivative transaction. 1. Forecast Have a view on the markets Build a credible market scenario Compare it with market consensus, for example implied forward curves. 2. Analyze ` Work out your cashflows and your risks under various scenarios Determine your target cashflows if you are right and how much you are willing to lose if you are wrong Reviewing the derivative transaction 3.Replicate Reverse engineer the transaction by decomposing it into its basic building blocks. De-leverage it if necessary. Understand its implied trading Gibson

Financial Derivatives : An International Perspective

strategy. Understand which variables have the greatest impact on the value of the transaction 4. Simulate Compute the transactions break

even and its evolution with the passage time and under different scenarios Compute the leverage over time and under changing scenarios 5. Scale Determine the optimal size and

leverage of the transaction. 6. Commit Tie your dealer down to a maximum bid/ask spread quote frequency and dealing size. What does his price represent a dealing price or a

theoretical mid market valuation. Check his pricing methodology, his credit standing and check prices with other market makers. Approving the derivative transaction 7. Authorise Who can commit the firm to a transaction, what and how much can he commit to, and with whom

Financial Derivatives : An International Perspective

Under what conditions can he commit the firm to a transaction, especially new structures with which the firm is not familiar. 8. Limit Determine the acceptable overall risk profiles over time. For market risk, this includes risk limits for the

Greeks i.e, separate limits for delta, gamma, vega . For credit risk, there should be counterparty limits, and

concentration

collateral

triggers and other sorts of credit enhancements in place. 9. Establish Ensure that the appropriate systems, procedures, accounting

documentation and people are in place and able to keep abreast with the changing dynamic of a derivative transaction. Entering transaction. 10. Monitor Set individual adjustment points in advance : for e.g. stop loss limits or profit lock ins which trigger an into the derivative

automatic close out of a transaction once they are breached . Establish

Financial Derivatives : An International Perspective

procedures and the people who have authority to override these automatic close out triggers.

Analysis BT securities representatives made material misrepresentations and

omissions in the offer and sale of derivatives to Gibson Greetings. During the period from October 1992 to March 1994. BT Securities representatives visted Gibson about the value of the companys derivatives positions by providing Gibson with values that significantly understated the magnitude of Gibsons loses. As a result, Gibson remained unaware of the actual extent of its losses from derivatives transactions and continued to purchase derivatives from BT Securities. In addition, the valuations provided by BT securities representatives caused Gibson to make material understatements of the companys unrealized losses from derivative transactions in the notes to its 1992 and 1993 financial statements. In a conversation of February 23 , 1994 taped by an internal BT Securities taping system, a BT Securities managing director discussed the differential between the compute model value of Gibsons positions and the valuation provided to Gibson. I think that we should use this (a downward market price movement) as an opportunity . We should just call (the Gibson contact) and may be chip away at the different a little more. I mean we told him $8.1 million when the real number was 14. So now if the real number is 16 well tell him that it is it.

Financial Derivatives : An International Perspective

You know, just slowly chip away at the differential between what it really is and what we are telling him. Later the same day the managing director stated in response to a question about whether he intended to provide Gibson with values for its positions that day. I want to and the reason is that - the problem is that we are too far away between what he thinks it is and what reality is . And you know, if this continues on and on like this. we are going to have start unwinding. And I dont think that we want to be in a position of unwinding something thats worth. I am exaggerating but worth $20 million and he thinks that its $11 million . You know we gotta try and close that gap. And I think that on days where theres a big move its, an opportunity to close the gap. If the market hadnt changed at all or was just kind of dottering around within a couple of ticks then you know theres nothing that we can really say. He is going to keep thinking that it is around $ 8.1 million . when it is really $1.4 million. You know which is what it was yesterday . But when theres a big move you know if the market backs up like this and he is down another 1.3 we can tell him he is down another 2 . And vice versa. If the market really rallies like crazy, and hes made back a couple of million dollars, you can say you have only made back a half a million. On two occasions when Gibson sought valuations for the specific purpose of preparing its financial statements, representatives of BT Securities provided Gibson with valuations that differed by more than 50% from the value generated by the computer model value and recorded on Bankers Trusts books . In early February 1993, Gibson asked representatives of BT securities for the value of its derivatives as of December 31. 1992 and stated

Financial Derivatives : An International Perspective

that the information could be used in preparing Gibsons 1992 year end financial statements. As of December 31, 1992, Bankers Trusts books reflected a negative value of $ 2129209 for Gibsons derivatives positions. BT securities, however, provided Gibson with a mark to market value for the derivatives positions of a negative $1025000, a difference of $1104209 or 52%. The next fiscal year, in a letter dated December 31, 1993, Gibson asked representatives of BY Securities to provide Gibson with the value of Gibsons Derivatives as of that date to use in preparing Gibsons 1993 year end financial statements. As of December 31, 1993 Bankers Trusts books reflected a negative value of $ 7470886 for Gibsons derivatives positions. Representatives of BT Securities, however, provide Gibson with a a mark to market value for the derivatives positions of negative $ 2900000 a difference of $ 4570886 or 61%.The value that BT Securities provided to Gibson as of December 31, 1993 related to spread lock 1 and wedding band 3. On October 1,1992, BT Securities and Gibson entered into the ratio swap BT securities represented to Gibson that the ratio swap has a negative value of $ 975000. In fact, as of December 31, 1992, Bankers Trusts Computer models showed that the ratio swap had a negative value to Gibson of $ 2003929. By mid February 1993, according to Bankers Trusts computer models the value of the ratio swap had improved to a negative value of $1,38000 to Gibson. However BT securities failed tO inform Gibson of the improvement in the value of the ratio swap at the time BY securities presented proposals for restructuring the ratio swap. Unaware of this information. Gibson entered into

Financial Derivatives : An International Perspective

a Treasury linked swap on February 19, 1993 as a means of reducing the risk on the ratio swap. In return for entering into the Treasury linked swap the maturity of the ratio swap was shortened from five years to four years. On February 19.1993, the day Gibson entered into the Treasury linked swap . Bankers Trusts books and computer models indicated that the fifth year of the ratio swap had a negative value of Gibson of $851700. At the time BT Securities representatives knew that Gibson would incur a loss $2.1 million, composed of an unrealised loss Securities representatives also knew that Gibson was unaware that it would incur the unrealized loss. On August 14,1993, Gibson agreed to enter into the time swap. As part of the transaction. Gibson agreed to terminate the periodic floor entered into on October 30, 1992 and amend the knock out call entered on June 10, 1993. BT securities representatives had proposed that Gibson enter into the transactions to preserve an opportunity for substantial gain BT securities representatives knew that as a result of these transactions., Gibson would sustain approximately $ 1.4 million in unrealized loses built into the structure of the time swap, but failed to disclose that information to Gibson. the cost of entering into the time swap was almost equal to Gibsons maximum possible profit on the knock out call. Approximately one week later, as the yield on the 30 year US Treasury security continued to decline. BT Securities representatives proposed that Gibson again amended the knock out call this time in exchange for adjusting the leverage factor in the time swap. On August 12, 1993, Gibson accepted the proposal and entered into an amendment of the knock our call and

Financial Derivatives : An International Perspective

increased the leverage factor in the term swap, By entering into these transactions, Gibson unknowingly sustained unrealized loses of

approximately $ 89000. Several week later, BT securities representatives proposed that Gibson enter into yet another amendment to the knock out call in exchange for restructuring the time Swap. A BT Securities. representative told Gibson that the time swap continues to look pretty good. In fact, at that time, the time swap held a substantial negative value to Gibson. Gibson agreed to purchase the amendment to the knock out call on August 26, 1993 by entering into another amendment to the knock out call in

exchange for restructuring the time swap. A BT securities representative told Gibson that the term swap continues to look pretty good. In fact, at that time, the time swap held a substantial negative value of Gibson. Gibson agreed to purchase the amendment to the knock out call on August 26, 1993 by entering into another amendment to the time swap . By entering into these transactions, Gibson unknowingly incurred unrealised loosed and transactional charges of approximately $578000. The next day Gibson agreed to terminate the Knock out call and was paid $475000 by Bankers Trust. In the amendments to the knock out call Gibson unknowingly incurred unrealized losses of $3 million built into the structure o the time swap . In comparison, the maximum possible payout of the barrier option never exceeded $2.3 million. On January 11, 1993 and May 6, 1993 BT securities and Gibson entered into spread lock 1 and 2 respectively. In September 1993, BT securities

Financial Derivatives : An International Perspective

recommended that Gibson amend each spread lock to reduce the amount of Gibsons payment to bankers Trust n the swaps. On September 22, 1993, BT securities and Gibson amended and restructured spread lock 1 and 2 by entering into wedding band 3 . On the same day, Bankers Trusts books showed a positive value for Gibson of the amendments to the spread lock of approximately $1.4 million. thus by entering into these transactions Gibson unknowingly incurred an unrealized loss and transactional charges of approximately $ 1020000. On January 14, 1994, BT securities and Gibson terminated spread lock 1 and 2 and the time swap , and entered into the LIBOR linked payout swap and wedding band 6 . On January 13, BT securities representatives misled Gibson by stating that Gibson would not go further in the hole by entering these new positions, when , in fact Gibson immediately incurred an additional unrealized loss of approximately $ 4954000. On February 23, 1994, BT securities representatives told Gibson that the value of Gibsons derivatives portfolio was negative $8.1 million when, in fact, the value that Bankers Trust carried on Bankers Trust s booked on that date was nagative $ 15.45 million On February 25, 1994, BT securities representatives told Gibson that the value of Gibsons derivatives portfolio was negative $13.8 million when, in fact, the value in Bankers Trust carried on Bankers Trusts booked on that date was negative $16.25 million.

Financial Derivatives : An International Perspective

Metallgesellschaft : A hedge too far The company MGs is a large diversified metals, mining and industrial conglomerate. In 1993 is had a turnover of DM26 billion ($15 billion). It US subsidiary, MG Refining Marketing (MGRM), built up a substantial business during the 1980s and early 1990s supplying oil and oil-related products such as diesel, gasoline and heating oil to some 500 large customers including retail gasoline suppliers, manufacturing companies and government

departments. In November 1991, MGRM recruited a new president. Arthur Benson brought with him a 50-person team. Benson and worked for MGs US operations in the 1980s, marketing oil product contract until being made redundant in 1988. He had moved to Louis Dreyfus Energy where, in the summer of 1990, a seemingly disastrous position in jet fuel was turned into a rumour $500 million profit by the Iraqi invasion of Kuwait. The customer contracts During the eighties, worries about the security of oil supplies gradually receded as the price of crude oil dropped from $35 to $12/barrel. Then in 1990, with the Iraqi invasion of Kuwait, prices doubled from US $18 to US $36 per barrel within days. Many oil consumers found they were in a vicious squeeze - supplies disappeared, prices soared and in many cases they were unable to pass on the increased costs in full to their customers. The Gulf War gave oil distributors and consumers a reminder of the volatility of oil prices and of the pain caused by a sharp rise in t prices. Benson

Financial Derivatives : An International Perspective

spotted an opening for his salesmen. MGRM would supply agreed monthly quantities of oil products on fixed - price long-term contracts (between five and 10 years). By covering a fraction (typically no more than 20 per cent of their demand) in this way customers could protect themselves in a simple and effective fashion from a sudden spike in the oil price. They could not insulate themselves permanently from a rise in oil prices but they could buy time until they could pass it on to their customers. MGRM also offered customers the option of liquidating the contracts early if the futures price rose above the fixed supply price. In such a case customers could require MGRM to pay them one half of the difference between the two prices on the remaining volume to be delivered under the contract. This opened up the attractive prospect of being able to turn another oil price spike into a huge cash windfall. At the same time customers could be reassured that a long-term fall in oil prices would not threaten their liability. Since the obligation to buy oil from MGRM at fixed prices would only cover some 20 per cent of their requirements, they would be able to exploit any fall in oil process on the remaining 80 per cent. Hedging the contracts MGRM could not buy the oil and store it to deliver to customers later financing and storage costs would make the transaction quite uneconomic. Nor could MGRM simply hope that it would be able to buy the oil cheaply when the tome came to deliver oil prices could easily rise by 50 per cent, leading to huge losses.

Financial Derivatives : An International Perspective

It would have to hedge itself in the financial markets. The obvious instruments to use were the oil futures contracts traded on the New York Mercantile Exchange (Nymex). By December 1993, MGRM had signed contracts with customers that committed it to delivering some 160m barrels of gasoline and heating oil over a 10 - year period ( a total value of around $4 bn). One third of this (55m barrels) was hedged using Nymex contracts. The rest (110m barrels) was hedged on the over-the-counter (OTC) market through oil swaps. These swaps resembled the Nymex contracts. The hedging strategy goes wrong Sport oil prices fell from $21.65 per barrel on September 30, 1992 to US $13.91 pre barrel on December 17 1993. As a direct result, MGRM had to pay out more than $1.2 billion on its hedge. The financial problems caused by margin calls were exacerbated in December 1993 by Nymexs decisions to impose super margin (more than twice the normal margin levels) and to revoke MGRMs hedger exemption, thus obliging it to put more cash as security and to reduce substantially its open positions.A special meeting of he MG supervisory board was convened on December 17 to consider the preliminary results of investigations by Deutsche Bank and Dresdner Bank (which were large shareholders as well as lenders) into the groups liquidity. They did not accept the strategy pursued by MGRM. MGs chairman, Hans Schimmalbusch , was removed after being accused of not keeping the board properly informed of the problems in the US

Financial Derivatives : An International Perspective

operations.His finance director was also fired, while two other directors were forced into retirement and a further two demoted. Between December 20 and 31, MGRM liquidated most of its futures and swaps positions. It liquidated its forward physical delivery contracts, wining the amounts potentially receivable under its customer contracts. Assessment of the strategy The losses at MGRM prompted a fierce debate about whether whether the strategy was fundamentally flawed or whether it was a good strategy that was prematurely and unnecessarily aborted. to assess the strategy,it is necessary to understand the risks faced by MGRM even after hedging the oil price risk : The contracts extended five or 10 years futures contracts do go out to 36 months but the longer dated contracts are too illiquid to be of much use. Most of MGRMs trading was in the near months. This made MGRM vulnerable to variations in the relative price of short and longer term contracts. The strategy required MGRM to do a lot of trading. At its peak MGRMs oil purchase requirements equaled about 20 per cent of the total open interest in the Nymex crude oil futures contract MGRM was heavily dependent on the continuing depth and liquidity of the market to enable it to roll its positions at reasonable cost. The oil products it was contracted to deliver were not identical to the products traded on the exchange. The company was at risk from variations in the prices of different oil products.

Financial Derivatives : An International Perspective

Losses and gains on the futures markets appear as cash immediately losses and gains on delivery contacts appear at the time of delivery. MGRM was vulnerable to fluctuations in funding costs.

If oil prices fell (as they did) MGRM would be vulnerable to customers defaulting on their purchase commitments.

In the face of all these risks (and with the benefits of hindsight about the size of losses) it is tempting to assert that the strategy was always a gamble . That is not fair. The strategic concept was quite defensible. There was clearly a demand among customers for long term fixed price oil contracts. There was apparently little competition and consumers were not well placed to provide the service themselves. So there was potentially a profitable opportunity to be exploited by someone who could manage the risks effectively. The question to be asked is not whether the transaction was risky but whether the expected profits were large enough to compensate for the risks and whether the strategy was implemented in a sensible way. Potential profitability The single most important source of risk (and of profit) for MGRM was the mismatch between the long term maturity of its liabilities and the short term maturity of its hedge. To understand the nature of this, consider the following simplified example. MGRM contracts to sell one barrel of oil in five years time. It hedges by buying one barrel f oil six months for ward. In six months time, it closes out

Financial Derivatives : An International Perspective

the position in what is now a maturing contract and buys a new six month contract. Assume zero interest rates and ignore financing issues The accountant who keeps the profit and loss account needs to put a value on MGRMs liability to supply the barrel of oil. He uses the price of the futures contract the MGRM is using for hedging as a proxy for the five year price.

This is not the cleverest or most prudent accounting system. Suppose that MGRM signs the contract at $22/barrel when the six month futures contract is $20 barrel. The accountant records an immediate profit of $2/barrel. After six months, the price on the contract, which is now near maturity, has gone to, say $25/barrel MGRM will have made $5 profit on the rise in the price of the futures. But the accountant will say that this is exactly offset by an increase of $5 in the cost of meeting its commitment to supply. So the hedge appears to be perfect. But now MGRM has to liquidate its futures position and buy one of the new six month contracts. Suppose that the six month contract is trading at $24/barrel $1 less than the spot. As MGRM switches contracts the accountant will reduce the valuation on MGRM s liability to supply from $25 to $24 so creating a profit of $1/barrel. A revaluation will occur every time the hedge is rolled forward. By the end of five years, the total profit made by MGRM will therefore be the sum of two components, the difference between the contract price and the spot price and the difference between the spot price and the six month futures price each time the contract is rolled over MGRMs profit depend on whether the market is in backwardation over the life of the supply contracts. Backwardation is

Financial Derivatives : An International Perspective

when the price for long term delivery falls below the price for immediate delivery. Backwardation in the oil market Over the period 1986 to 1992 the degree of backwardation averaged some $0.14/barrel/ month. Had MGRM written a contract to supply oil in five years time at a price equal to the current spot price and had it hedged by rolling short maturity futures contracts, It would have generated a profit of $8.40/barrel. This may exaggerate the potential gain since it includes the Gulf War when backwardation was enormous. If that period is ignored, the average level of backwardation is halved. But even profits of $4 per barrel are substantial. Backwardation has been quite persistent but its causes are not well understood and it might not persist at historic levels. The very fact that customers were prepared to buy oil long term at or above the sport price when the term structure of futures prices is downward sloping suggests a degree of disequilibrium that would attract other traders to follow MGRM. This could well lead to a decline in backwardation. MGRMs strategy meant that it had to be in the market on a permanence basis, rolling out of its position in maturing contracts into slightly longer dated contracts. Such a strategy was likely to affect the prices it faced given the large amounts with which it was operating and this too would tend to reduce profitability.

Financial Derivatives : An International Perspective

Historical evidence gives grounds for believing in continuing backwardation and hence in the profitability of writing long term contracts at or above current prices. But their was never any certainty that MGRMs strategy would be profitable. Financing the strategy There were substantial risks in a strategy of hedging long commitments using short dated futures. The calculations suggest that on the most favourable assumptions the risk was likely to be around $3/barrel. That is to say, if MGRM hedged as closely as possible, hedging changes in the slope of the term structure as well as in its level, it could easily end upmaking $3 more or less per barrel than expected. Thus, even if the future broadly resembles the past, it is likely that the strategy will fail to make money. The fact that the best hedge is not very good affects the financing of the position. If the hedge is demonstrably a good one, there is likely to be little problem in getting a bank or other institution to finance it. They are lending against an asset whose value is known to exceed the debt. But if the hedge is risky, a bank will not fianance it because it would bear the loss if things turn out badly without sharing the profit if they go well. The strategy needs to be finance with equity. MG itself needed to set aside enough capital to absorb potential losses other wise it face the risk of having to liquidate its position prematurely. It requires that the strategy be understood throughout the company and by its investors, and this understanding appears to have been lacking. Implementation

Financial Derivatives : An International Perspective

MGRM seems to have bought one barrel of futures for every barrel of oil to be sold . This would lead to overhedgingfor two important reasons. First, a $1 increase in the spot price of oil is unlikely to imply a $1 increase in the price of delivery in five years. Many factors might affect the short term supply /demand balance that have little significance for long term prices. Over 1993, the spot and near term futures moved down far more sharply than longer term futures. The losses on the hedge were far larger than the expected profits on the supply contracts. The second reason is that a $1 fall in the oil price at all maturities costs the company $1 today on the futures market the Corresponding $1 gain in the supply contract only occurs when the oil is supplied. The overhedging means that MGRM was net long oil as the oil price fell it was actually losing money. If the minimum risk hedge was o.5 to 1 rather than 1 to 1 then roughly half the loss that MGRM incurred was due to the fact that intentionally or not, it had a huge exposure to the oil market when the oil price was failing very sharply. The most difficult question to resolve is how much of the loss can be attributed to the decision to unwind the contracts at the end of 1993. Customers were committed to buying large volumes of oil from MGRM at what was by then a huge premium to the spot price. These contracts seem to have been terminated without MGRM extracting any value from them. Yet to theory they were valuable to MGRM worth many hundreds of millions of dollars.

Financial Derivatives : An International Perspective

Realising this value required a continued hedging program, with the associated financing it would not have been riskless there was always a fear of customer defaults. Yet it is hard to believe that the best solution was to tear them up. Lessons MGRMs role was similar to that of a financial intermediary. It recognized that clients were prepared to pay a premium for a service above its fair market value. It designed a product to meet that need and a hedging strategy that passed most of the risks to the market. It kept some risks that it managed in house. The problems appear to have been of two kinds. First MGRM took on, intentionally or not, a huge amount of oil price risk that it need not have done. It is not clear that it had any particular expertise in guessing the level of the oil price. Second MGRM did not ensure it had enough capital to hold to its strategy as the market moved a way from it. It was trying to exploit a deviation between the price at which customers were prepared to buy oil and its estimate of the equilibrium price. Large and persistent deviations can only be exploited with some risk. If deviations exist, they can get worse. An institution seeking to exploit them needs to have the financial strength to see the transaction through to the end a forced exist is almost bound to be costly. In MGRMs case that meant having the commitment and understanding of both its parent and its bankers. The parent needed to understand and accept

Financial Derivatives : An International Perspective

the risks it was taking and the bankers needed to be convinced they were lending no more than could be confidently recovered from Clearly that was lacking. customers ,

Financial Derivatives : An International Perspective

L.C. Gupta Report L.C. Gupta pannel set up by security and Exchange Board of India recommended a phased introduction of derivatives trading in Country. The committee strongly favours the introduction of financial derivatives for hedging in the most cost-efficient way against the market risks. The various guidelines given by L. C. Gupta pannel are : 1) Introduce derivatives in phases. 2) Stock Index futures should be first off the block. This view of committee is based on careful examination of the findings of a survey. The survey covered mutual funds, financial institutions, commercial banks, investment banks and stock brokers. Replies were recovered from 67 brokers, 10 mutual funds, 14 banks and FIs 12 FIIs and nine merchant banks. Survey of mkt player shows 70% wants derivatives for hedging

Only 36% want to be option writers, 64% want to be brokers.

Three month duration most favourable.

33% except very fast trading growth of under futures and options.

3) Removal of regulations prohibitions on the entry of Mutual Funds in the derivatives market.

Financial Derivatives : An International Perspective

Pannel says that mutual fund need hedging facility, but should only be allowed to use financial derivatives for hedging, including anticipated hedging and portfolio rebalancing with in the policy frame work laid down by the board of trustees of funds who would specify the types, schemes and limits of the use of derivatives. 4) Regulatory frame work should be set up at exchange level. SEBI should approve the rules, bye-laws and regulations of the derivatives exchange. SEBI should not be involved in framing exchange level rules. Every

derivative member should be inspected by the derivative exchange annuals.

5) There should be a 2 tier system of trading members. Two level system will be through clearing and non-clearing members. Capital adequacy of Rs 3 crore and entry level exam for clearing member. Non-clearing member will depend on clearing member for trade settlement. The clearing mechanism should be independent, in the from of clearing corporation. The clearing corporation will collect initial margin linked with the exposure limits of the broker or dealer. The governing board of the clearing corporation should be immune to any interference of direct/indirect pressure by trading interests.

Financial Derivatives : An International Perspective

The clearing corporation should modify the margin requirementsin tune with market volatality. An independent centralised clearing corporation for all stock exchanges should be set up. Untill that is created, separate clearing houses, may continue to be used by the existing exchanges provided the following conditions are satisfied : The clearing house unconditionally guarantees all the derivative deals executed on the exchange and The exchange agrees to participate in the central clearing corporation as and when that entry comes up. 6) Derivatives exchange should have at least 50 members to start. 7) Clearing corporation should have a settlement guarantee fund. 8) Daily mark to margin is set at 10%. 9) The maximum exposure traders would be permitted is 10 times the upfront margin deposited by members.

Financial Derivatives : An International Perspective

HOW LEESON BROKE BARINGS The activities of Nick Leeson on the Japanese and Singapore future exchanges which led to the -documented. Barings collapses because it could not meet the enormous trading obligations which Leeson established in the name of the bank. When it went into receivership on 27 February 1995, Barings, via Leeson, had outstanding notional futures positions on Japanese equities and interest rates of US $27 billion: US$7 billion on the Nikkei 225 equity contract and US$20 billion on Japanese government bond (JGB) and European contracts. Leeson also sold 70892 Nikkei put and call options with a nominal value of $6.68. The notional size of these positions is breathtaking their enormity is all the more astounding when companies with the banks reported capital of about $615 million. The replacement value of these contracts was US$ 1.05 billion for the Nikkei 225 futures potions (0.15 x $7 billion) and US $60 million for the Japanese interest rate obligations (0.003 x $ 20 billion). Since the option contracts were split roughly equally between put and call options with the same strike prices on maturities, one can justifiably assume that only half of the options had positive replacements value with the other half worthless. On this assumption, the replacement value of he options was US$501 million (0.15 x $3.34 billion). Thus the estimated total replacement value of Leesons positions at US$1611 million was more than two and a half larger than Barings capital. downfall of his employer, Barings, are well

Financial Derivatives : An International Perspective

The size of the positions can be underlined by the fact that in January and February 1995, Barings Tokyo and London transferred US $835 million to its Singapore International Monetary Exchange (SINEX). Reported Activities (Fantasy) The build - up of the Nikkei positions took off after the Kobe earthquake of 17 January. This is reflected in Figure 1 The chart shows that Leesons positions went in the opposite direction to the Nikkei - as the Japanese stock market fell, Leesons position increased. Before the Kobe earthquake, with the Nikkei trading in a range of 19000 to 19 500, Leeson had long futures positions of approximately 300 contracts on the Osaka Stock Exchange. (The equivalent number of contract on the Singapore International Monetary Exchange is 6000 because SIMEX contracts are half the size of he OSE). A few days after the earthquake Leeson started an aggressive buying prorgamme which culminated in a high of 19094 contracts reached about a month later on 17 February. Graph ---------Figure 1. Barings Long Positions against The Nikkei 225 Average. Source : Datastream ad Osaka Securities Exchange. But Lessons Osaka position, which was public knowledge since the OSE publishes weekly data, reflected only half of his sanctioned ltrades. If Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX. Because Leesons official trading strategy was to take advantage of temporary price differences between the SIMEX and OSE Nikkei 255 contracts. This arbitrage which Barings called switching, required Leeson to

Financial Derivatives : An International Perspective

buy the cheaper contract and to sell simultaneously had narrowed or disappeared. This kind of arbitrage activity has little market risk because positions are always matched. But Leeson was not short on SIMEX : in fact he was long approximately the number of contracts he was supposed to be short. These were unauthorized trades which he hid in an account named Error Account 88888. He also used this account to execute all his unauthorized trades in Japanese Government Bond and European futures and Nikkei 225 options : together threes trades were so large that they ultimately broke Barings. Table 1, gives a snapshot of Leesons unauthorized trades versus the trades that he reported. Unreported Positions (Fact) The most striking point of Table 1, is the fact that Leeson sold 70892 Nikkei 225 options worth about $7 billion without ht knowledge of Barings London. His activity preached in Nevermore and December 1994 when in those two months alone. Table 1, Fantasy Versus Fact : Leesons Positions as at End February 1995 Number of contracts nominal value in US$ amounts Actual position in terms interest of open of

relevant contract2 Reported3 Futures Nikkei 225 30112 $2809 Long 61039 49% of March Actual4

Financial Derivatives : An International Perspective

million

$7000 million

1995

contract

and 24% of June 1995 contract. JGB 15940 million $8980 short28034 $19650 million 5% of June 1995 contract and 88% of June 1995

contract. European 601 $26.5 million short 6845 $ 350 5% of million 1995 June contract,

1% of September 1995 contract an d1% December contract. Options Nikkei 225 Nil 37925 $3580 32967 $3100 million calls million puts of 1995

he sold 34400 options. Leeson sold straddles, i.e. he sold put and call options with the same strikes and matturities. Leeson earned premium trades are very profitable provided the Nikkei 225 is trading at the options strike on expiry date since both the puts a call would expire worthless.

Financial Derivatives : An International Perspective

The strike prices of most of Lessons straddle positions ranged from 18500 to 20 000. He thus needed the Nikkei 225 to continue to trade in its pre-Kobe earthquake range of 19 000-20 000 I the was to make money on the day of the quake, 17 January, the Nikkei 225 was at 19350. It ended that week slightly call options Leeson had sold were beginning to look worthless but the put options would become very valuable to their buyers if the Nikkei continued to decline of the Nikkei at expiry, while the profits on the calls were limited to the premium earned. Prior to the Kobe earthquake this unauthorized book, i.e. account 88888 showed a flat position in Nikkei 225 futures. Yet on Friday 20 January, these days after the earthquake, Leeson bought 10 814 March 1995 contracts. No one is sure whether he bought these contracts because he thought the market had over-reacted to the Kobe shock or because he wanted to shore up the Nikkei to protect the long position which arose from the option straddles. When the Nikkei dropped 1000 points to 17950 on Monday 23 January 1995, Leeson found himself showing losses on his two-day old long futures position and facing unlimited damage from selling put options. There was no Turing back. Leeson, true to the image of traders as masters of the universe third singlehandedly to reverse the negative post-Kobe sentiment that swamped the Japanese stock market. On 27 January, account 88888 showed a long position of 27158 March 1995 contracts. Over the next three weeks, Leeson sounded this long position to reach a high on 22nd February of 55206 March 1995 contacts and 5640 June 1995 contracts.

Financial Derivatives : An International Perspective

Leeson lost money from his unauthorized trades almost from day one. Yet he was allegedly perceived London as the wonder boy and turbo-arbitrageur who single-handedly contributed to half of Barings Singapores 1993 profits and half of the entire firms 1994 profits. The wide gap between fact ad fantasy is illustrated in Table 1, which not only shows the magnitude of

Leesons recent losses but the fact that he always Lost money. In 1994 alone, Leeson lost Baring s -- 185 million (US$296 million); his bosses thought he made them 00 29 million (US$46 million), so they proposed paying him a bonus of -- 450000 (US$ 720000).Table 2, Fact versus fantasy : Profitability of Leesons Trading Activities. Period Reported Actual Cumulative actual 1 Jan 1993 to 31 + -- 8.83 million Dec 1993 1 Jan 1994 to 31 + Dec 1994 -28.529 - -- 185 million - 208 million - -- 21 million - -- 23 million

million -18.567 - -- 619 million - --827 million

1 Jan 1995 to + Feb 1995

million

Source : Report of the Board of Banking Supervision Inequity into the Circumstances of the Collapse of barings, Ordered by the House of Commons, Her Majestys Stationery Office, 1995. The Cross -trade How was leeson able to deceive everyone around him? How was he able to post profits on this switching activity when he was actually losing? How as he able to show a flat book when he was taking huge long positions on the

Financial Derivatives : An International Perspective

Nikkei and short positions on the Nikkei and short positions on Japanese interest rates? The Board of Banking Supervision (BoBs) of the Bank of England which conducted an investigation into the collapse of Barings believes that the vehicle used to effect this deception was the cross trade. A cross-trade is a transaction executed on the floor of an Exchange by just one Member who is both buyer and seller. If a Member has matching buy and sell orders from two different customer accounts for the same contract and at the same price, he is allowed to cross the transaction (execute the deal) by matching booth his client accounts. However he can only do this after he has taken it up. Under SIMEX rules, the Member must declare the prices three times. A cross-trade must be executed at market-price. The BoBs unquity notes, Barings future Singapore [Leeson was general manager of BFS] entered into a significant volume of cross transaction between account 88888 and account 92000 )Barings Securities Japan -Nikkei and JGB Arbitrage), account 98007 (Barings London - European Arbitrage) ... Many of the crosses transacted by BFS appear to have taken place in the post -settlement period a period of three to five minutes after the official close where trading is allowed only at there official settlement price. It is likely that Leeson chose this period as being one where other market operators were least likely to wish to participate in the transaction, which they were entitled to do under the rules of SIMEX. It appears that after the conclusion of the trade, Leeson would instruct the settlements staff to break down the total number to cause profits to the

Financial Derivatives : An International Perspective

creadited to the switching accounts refereed to above and lossed to be charged to account 88888. Thus while the cross - trade on the Exchange appeared on the face of it to be genuine and within the rules of the Exchange, the books and records of BFS maintained in the Contact system a settlement system used extensively by SIMEX members, reflected pairs of transactions adding up to the same number of lots at prices bearing no relation to those executed on the above but when these were entered into cross - trades of smaller size than the above but when these were entered into the Contact system he would arrange for the price to be amended, again enabling profit to be charged to account 88888 LESSONS FROM LEESON The lessons from the Barings collapse can be divided into five main heading and are discussed below. Segregation of Front and Back-office Duties The management of Barings broke a cardinal rule of any trading operation they effectively let Leeson settle his own trades by putting him in charge of both the dealing desk and the back office. Abusing his position as head of the back office, Leeson suppressed information on account 88888. This account was set up I July 1992 - it was designated London client account in SIMEXs system. But Barings London did not know of its existence since Leeson had asked a systems consultant, Dr. Edmund Wong, to remove error account 88888 from the daily reports which BFS sent electronically to London. This state of affairs existed from on or around 8 July 1992 to the collapse e of Barings on 26 February 1995.

Financial Derivatives : An International Perspective

(Information on account 8888 was however still contained in the margin file sent to London). Error accounts are set up to accommodate trades that cannot be re concealed immediately. A compliance officer investigates the trade, records them on the firms books and analyses how it affects the firms Trading Manual of 1994 insists that good internal controls means segregation of front and back-office duties. Banks must ensure. Separation of duties as supervision to insure that persons executing transactions are not involved in approving the accounting methodology or retries. Further, persons executing transactions should not have authority to sing incoming or outgoing condirmantons or contracts, reconcile records, clear transactions, or control the disbursement of margin payments. Lack of Senior Management Involvement Thering leis the crux of the Barings collapse - senior managements lackadaisical attitude to its derivative operations in Singapore. Every major report on managing derivative risks has stressed the need for senior management to understand the risks of the business; to help articulate the firms risk appetite and control procedures needed to achieve these objectives. The recommendation of the G - 30 is on the role senior management. Dealers and end -users should use derivatives in a manner consistent with the overall risk management and capital policies approved by their boards of directors. These policies should be reviewed as business and market

Financial Derivatives : An International Perspective

circumstances change. Policies governing derivative use should be clearly defined including the purposes for which these transactions are to be undertaken. Senior management should approve provesures and controls to implement these plaices and management at all levels should enforce them. Before engaging in derivative activities, management should ensure that all appropriate approvals are obtained and that adequate operational

procedures and risk control systems are in place. Proposals to undertake derivative activities should include : a description of the relevant financial products, markets and business strategies; the resources required to establish sound and effective risk management to attract and retina professional with specific expertise in

systems and

derivative transactions; an analysis of the reasonableness of the proposed activities in relation to

the institutions overall financial condition and capital levels; an analysis of the risks that may arise from the activities;

the procedures the bank will use to measure, monitor and control risks.

Adequate Capital Institutions should ensure that its capital position is sufficiently strong to support all derivative risks on a full consolidated basis and that adequate capitals maintained in all groups engaging in these activities

Financial Derivatives : An International Perspective

Thus an institution must have sufficient capital to withstand the impact of averse market moves on its outstanding positions as that Leesons positions were these positions going. Barings management thought that Leesons positions were market neutral and were thus quite happy to fund margin requirements till the contracts expired. In the end these collateral calls from SIMEX and OSE proved too much to bear and the 200 year old institution was forced to call in the receivers. It was funding risk that seriously wounded Barings but the terminal shot came from the discovery that the enormous positions were unhedged. Poor Control Procedures Barings control procedures were sloppy. Barings did not require Leeson to distinguish between variation margin needed to cover proprietary and customer trades; neither did it have a system to reconcile the funds Leeson requested to his reported positions and or that of its client positions. London simply, automatically, remitted to Leeson the sum of money he requested, despite misgivings about the accuracy of his data. For example senior staff in Londons settlement and treasury function sere uncomfortable with the way Leeson broke down his US dollar funding requests. The fact that no one even asked Leeson to justify his requests is all the more astounding given the size of his demands. At the end of December 1994, the cumulative funding of BFS by Barings London ad Tokyo stood at -- 221 million (US$356 million). In the first two months of 1995, this figure increased by --521 million (US$835 million) to --742 million (US$1.2 billion).

Financial Derivatives : An International Perspective

In many trading houses, not only is there a separation of operational duties between the front and back office (absent in Barings), but there is also a unit independent of both to provide an additional layer of checks - and - balance Thus if is recommended that. Segregation of operational duties exposure reporting and risk monitoring from the business unit is critical to proper internal control. Proper internal control should be provided over the entry of transactions into the database,

transaction numbering date time notation and the confirmation and settlement procedures. The operations department or another unit or entity independent of the business unit, should he responsible for ensuring proper reconciliation of front and back office database on a regular basis. This includes the verification of position data, profit and loss figures and transaction-by -transaction details. No Limits Barings did not impose any gross position limits on Leesons proprietary trading activities because it felt that these was little market risk attached to arbitrage trades sine at the close of business, the position had to be flat. But the Barings collapse has shown that placing gross position limits on each side of an arbitrage book is perhaps not such a had idea afecter all. While it is true that an arbitrage book has little prove (directional) risk, it has basis and settlement risk. The former arises because prices in two markets do not always move in tandem and the later because different markets have different settlement systems, creating liquidity and funding risk.

Financial Derivatives : An International Perspective

The reasons why India needs derivatives are as follows : For market development because the Indian market lacks hedging facility against market risk to which equity holders are exposed to. To enhance efficiency & Liquidity of the cash market. For globalising Indian stock markets. To distributed the risks to whose to are willing to accept it. To reduce transaction costs of quickly rebalancing a large portfolio. To reduced agency costs. To estimate future price of the commodity. Various arguments against the introduction of financial derivatives question about which basic nee of the society these financial derivatives satisfies. The most sophisticated new financial product in the would will go nowhere if it does not meet the basic need of a society. Before introducing any future trading in India a question one need s to ask here is: who and how and how many are this investors who have genuin needs to hedge their market risk and who are the potential counter parties to such trade who are going to provide hedging. Only after assessing the demand and supply for hedging one should introduce an instrument which would serve a social purpose. To determine demand one would nee to know : How many investors (individual institutional) ion India hold and approximate the index portfolio? / or

Financial Derivatives : An International Perspective

What are the objectives in holding this portfolio? What is size of their portfolio? What are there hedging needs? At what price would they be seeking hedging? Would it be possible to have a reasonably continuous demand curve given the number of hedge seekers and their state prices preferences. Similarly on the supply side would there be a sufficient number of hedgers who would like to offset the opposite risks or liquidate another hedge as a result or a change I their positions in the cash markets. And if hedgers are few in number and if all hedge seekers are on the same side, which is most often the case, arbitrageurs and speculators would be needed to provide the other side of the transaction. For arbitrageurs to function properly we would need to examine the working of the case market because arbitrage would be done in spot and future markets. Two major hurdles in perfect arbitrage are tracking error - whether they would be able to trade in index portfolio or a mix of shares which would approximate the market risk inherent in their bought portfolio - minor error can wipe out their profits; and impact cost which rare current to execute such large in a brief time period. It the above is not possible in our existing cash markets, then only speculators are going to dominate the future markets. Speculators need to have large funds to operate and an appetite to take the risk. In India, one would need to assess the numbers of such players. If such numbers are small because of institutional and legal constraints which inhibit their operations, we would not be able to have a competitive market. Few speculators would be able to dictate the

Financial Derivatives : An International Perspective

markets because there would not be many left to provide the opposite side of the transactions. This question become more crucial when settlements are done in cash only and not by actual delivery. One would have no choice but to cater the contract at dictated prices. Pre-requisites, for the Introduction for derivatives in India Short sale and borrow/loan system These is enough evidence that the facility to sell short increases prices efficiency of cash equity markets, and this is essential for a derivatives market. Short sale is necessary to ensure that derivatives are properly priced. Without short sales, the link that arbitrageurs provide in ensuring the correct pricing of derivatives would be lost. Further, without the participation of institutional payers, the markets would be shallow. It is of paramount importance that legal changes changes should be brought about so that institutional players are able to sell short. Depository The levels of dematerialisation have to be of a much higher magnitude to ensure that the cost of arbitrage between the index and the underlying cash scrips can be done at a low cost and in an efficient manner. Funding requirement

Financial Derivatives : An International Perspective

The report is silent of the financing needs of arbitrageurs and market makers. If the arbitrage function is not performed well, there will be misfiring and the entire purpose would be lost. Creation of an electronic fund transfer facility Funds should be able to move from one place to another within hours. A delay would that the margin collection would mean that the margin would have to be increased to account for it. This would increase transaction costs and make derivatives that much less attractive. Buoyant debt market A liquid debt market is of paramount importance for arbitrageurs to park their funds for arbitrageurs to park their funds for short-term which can be used for arbitrage when an opportunity arises. This is even more important in a scenario where the banking sector chokes the supply of funds for these purposes. The banking system in the country has to respond to the changes in the capital markets and provide funds for such legitimate business.

Financial Derivatives : An International Perspective

SUMMARY AND CONCLUSION


Derivatives as the word implies are the synthetic by product created or derived from the value of there underlying asset we it a real or financial asset. The common belief that these derivatives are new is hot true, they have been around for years. The description of the first known option contract can be found in Aristotles writing. Investors use derivatives for four basic purposes: 1. To hedge risk 2. To speculate and profit from anticipated market movements. 3. To adjust portfolio quickly and cheaply. 4. To arbitrage price discrepancies in financial markets.

There are some common mis-beliefs about the derivatives that they are risky they create risk, they generate volatility, they are speculative investment etc. This derivatives instruments although very useful but can create disaster is they are not used properly. Various companies which have not been care full while using these derivatives have incurred huge losses. some of them are Name of the Company 1. Barings PLC. 2. Orange country 3. P & G Losses Sterling pound 860 million Sterling pound 1.7 billion US $157 million

Financial Derivatives : An International Perspective

4. Metallgesellschaft 5. Gibbson Greetings 6. Kashima Oil 7. Piper Jaffray 8. Merrill Lynch 9. Paine Webber 10. Nippon Steel 11. Air Products & Chemicals

US $1.4 billion US $ 27 million US $ 1500 million US $ 700 million US $ 377 million US $ 268 million US $ 128 million US $ 60 Million

In India with globalisation and more & more of foreign investors coming and due to the increased competition and exposure, the need fro these Derivatives as a hedging instruments were felt by the investors and the

Regulatory body. As a result a committee was set up by the SEBI to develop a approperiate regulatory frame work for introducing derivatives in India. After analyzing all the aspects of the market and also the needs of the investors, committee recommended the phased introduction of the derivative in India, starting with stock Index futures. Committee has come out with various recommendations but still the bye- laws have not been laid down. Also there are various questions that are raised about the introduction of derivatives in India. Like, Are we ready for the derivatives? Do we have adequate Infrastructure to deal with derivatives? Is the timing correct & finally what social benefits they are going to provide to small Investors. To analyse whether our market is ready for derivatives and what market participants thinks about them, I conducted a survey in Delhi, covering few brokers and officials of financial companies.

Financial Derivatives : An International Perspective